The Government Is Shut Down. Should You Be Worried?

The senate was not able to pass a temporary spending bill in the late hours of the night so as of Saturday, January 20th the government is officially shut down. But what does that mean? How will it impact you? What will be the impact on the stock market? 

Don’t Let The Media Scare You

The media loves big disruptive events.   Why?  The news is a "for profit" business.  The more viewers they have, the more profits they make.  What makes you watch more news?  Fear.  If the weather forecasts is 80 degrees and sunny, you just go on with your day.   Instead, if the weather is predicting “The Largest Winter Blizzard Of The Century”, my guess is you will be glued to the weather channel most of the day trying to figure out when the storm will hit, how many feet of snow is expected to fall, and are schools closing, etc. 

You will undoubtedly wake up this morning to headlines about “The Government Shutdown” and all of the horrible things that could happen as a result.  In the short term a government shutdown or a “funding gap” is not incredibly disruptive.  Many government agencies have residual funding to keep operations going for a period of time. Only portions of the government really “shut down”.  The “essential” government services continue to function such as national security and law enforcement.  The risk lies in the duration of the government shutdown.  If Congress does not pass either a temporary extension or reach a final agreement within a reasonable period of time, some of these government agencies will run out of residual funding and will be forced to halt operations. 

The news will target the “what if’s” of the current government shutdown.  What if the government stays shut down and social security checks stop? What if the U.S. cannot fund defense spending and we are left defenseless?   All of these scenarios would require a very prolonged government shutdown which is unlikely to happen. 

How Often Does This Happen?

number of days the government is shut down

When I woke up this morning, my first questions was “how often do government shutdowns happen?”  Is this an anomaly that I should be worried about or is it a frequent occurrence?  The last government shutdown took place on September 30, 2013 and the government stayed shut down for 16 days.   Prior to the 2013 shutdown, you have to go back to December 15, 1995.  The duration of the 1995 shutdown was 21 days.  Making the current government shutdown only the third shutdown between December 15, 1995 – January 20, 2018.  Not an anomaly but also not a frequent event. 

But let’s look further back.  How many times did the U.S. government experience a shutdown between 1976 – 2018?   In the past 42 years, the U.S. government has experienced a shutdown 18 times.  On average the government shutdowns lasted for about 7 days.  This makes me less worried about the current government shutdown given the number of shutdowns that we have overcome in the past. 

This Shutdown Could Be Longer

political polarization history

The only thing that worries me a little is the potential duration of the current government shutdown.  I would not consider two data points to be a new “trend” but it is hard to ignore that the last two government shutdowns that occurred in 1995 and 2013 were much longer than the 7 day historical average. However, this could be the start of a new trend given how polarized Congress has become.  It’s a clear trend that over the past 40 years fewer members of the Senate and House are willing to cross party lines during a vote.  See the chart below:  Back in 1973, only 73% of the members of Congress voted with the majority of their political party.   It  would seem rational to assume that during that time period members of Congress were more willing to step across the aisle for the greater good of the American people.  Now, approximately 95% of the members of both the House and Senate vote with their own camp.  This creates deadlock situations that take longer to resolve as the “blame game” takes center stage. 

Impact On The Stock Market

In most cases, injecting uncertainty in our economy is never good for the stock market. However, given the fact that U.S. corporations are still riding the high of tax reform, if the government shutdown is resolved within the next two weeks it may have little or no impact on the markets. 

If it were not for the recent passage of tax reform, my guess is this government shutdown may have been completely avoided.   Not choosing a side here but just acknowledging the Democratic Party was delivered a blow with passage of tax reform in December.  Since the spending bill requires 60 votes to pass in the Senate, it will require support from the Democrats.  This situation provides the Democratic party with a golden opportunity to negotiate terms to help make up for some the lost ground from the passage of the Republican led tax bill.   This challenging political environment could lengthen the duration of the government shutdown.  However, it’s also important to remember that neither party benefits from a government shutdown, especially in a midterm election year. 

Over the next two weeks, I would recommend that investors take all the media hype with a grain of salt.  However, if a permanent or temporary spending bill is not passed within the next two weeks, it could result in increased volatility and downward pressure on the stock market as government agencies run out of cash reserves and begin to put workers on furlough.     At this point, we are really in a “wait and see” environment. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

What Does Tax Reform Mean For The Markets In 2018?

2017 ended up being a huge year for the U.S. stock market.  The rally in the stock market was unmistakably driven by the anticipated passing of tax reform and Congress delivered. However, the sheer magnitude of the stock market rally has presented investors with a moment of pause and a lot of unanswered questions as we enter into the first quarter of 2018. The two main questions being:

• What does tax reform mean for the markets in 2018?

• We are now in the second longest economic expansion of ALL TIME!!! I know what goes up, eventually comes down. Are we overdue for a major correction in the stock market?

Without a crystal ball, no one knows for sure. However, the purpose of this article is to identify indicators in the economy and the financial markets that may help us gauge the direction of the U.S. economy and equity markets as we progress through 2018.

Tax Reform: Uncharted Waters

While tax reform is a welcome friend for corporate America, we have to acknowledge that this also puts us in uncharted waters. Looking back, there has never been a time in history where the U.S. has injected fiscal stimulus (tax reform) into an economy that is already healthy. The last major tax reform was in the early 1980’s when the U.S. economy was trying to dig itself out of the long 1970’s recession.

When the economy is in a recession, the U.S. can either inject fiscal stimulus or monetary stimulus to get the economy growing again. The U.S. used monetary stimulus to dig us out of the Great Recession of 2008 – 2009. They lowered interest rates to basically 0%, pumped cash into the economy in the form of bond buying, and provided a financial back stop for the U.S. banking system.

These economic stimulus tools are similar to the concept of giving a patient in a hospital a shot of adrenaline. If a patient is flat lining, it provides that patient with a huge surge of energy. The patient’s body goes from 0% to 60%+ in under a minute. So what happens when you give someone who is completely healthy a shot of adrenaline? Do they go from 100% to 110%? My point is a healthy patient does not go from 100% to 160%. Both patients get a boost but the boost to the healthy patient is much lower as a percentage of where they started.

While we have never given the U.S. economy an adrenaline shot after a long economic expansion, I think it’s reasonable to apply the same general concept as our two hospital patients. Tax reform may very well lead to another year of positive returns for the stock market in 2018 but I think it’s very important for investors to set a reasonable expectation of return for the U.S. equity markets given the fact that we are injecting growth into an economy that is already at “full employment”.

Not Enough Workers

One of the greatest challenges that the U.S. economy may face in 2018 is a shortage of qualified workers. Prior to tax reform being passed, companies both large and small, have had plenty of job openings but have not been able to find the employees with the skills necessary to fill those positions.

For example, if Apple had 1000 job openings in November 2017 just to meet the current demand for their goods and services but in 2018, due to tax reform, consumers have more money to spend, and the demand for Apple products increases further, Apple may need to find another 2000 employee to meet the increase in demand. They are having trouble now finding the 1000 employees to meet their current demand, how are they going to find another 2000 quick enough in 2018 to meet the increase in demand? If they can’t make the phones, they can’t sell the phones. Fewer sales equals less revenue, which equals less net profit, which may lead to a lower appreciation rate of the stock price. For disclosure purposes, I’m not picking on Apple. I’m just highlighting an issue that may be common among the companies that make up the S&P 500 Index if tax reform leads to a spike in demand in 2018. If Wall Street is expecting accelerated earnings, how are the companies expected to deliver those enhanced earnings without the employees that they need to increase supply?

The unemployment rate in the U.S. is currently 4.1%. You have to go all the way back to the late 1960’s to find an employment rate below 4%. So we are essentially at “full employment”.

Rising Wages

The blue line in the chart above is also very important. The blue line represents wage growth. This answers the question: "Are people making more for doing the same amount of work?" If you look back historically on the chart, when the unemployment rate was falling, typically wage growth was increasing. It makes sense. When the economy is good and the job market is healthy, companies have to pay their employees more to keep them. Otherwise they will go work for a competitor, who has 10 job openings, and they get paid more. Wage growth is good for employees but it's bad for companies. For companies, employee wages are usually their largest expense. If you increase wages, you are increasing expenses, which decreases profits. Lower profits typically results in lower stock prices. Companies in 2017 had the luxury of strong demand but limited wage growth. My guess is you will begin to see meaningful wage growth in 2018 as companies see an increase in demand as a result of tax reform and end up having to raise wages to retain and attract employees. This is just another reason why 2018 may be a good year for the stock market but not a great one.

What Fuels GDP Growth?

Gross Domestic Product ("GDP") is the economic indicator that is used to measure how much the U.S. economy produces in a year. It's how we gauge whether our economy is growing or contracting. Since March 2009, the GDP growth rate has averaged about 2.2% per year. This is subpar by historic standards. In most economic expansions, GDP is growing at an annual rate of 4%+.

Before we get into what pieces of tax reform may help to increase the GDP growth rate, let us first look at what GDP is made of. Our GDP is comprised of 5 categories (for my fellow econ nerds that assign 4 categories to GDP, we split capital spending into two separate categories):

• Consumption or "Consumer Spending" 69.1%

• Government Spending (includes defense) 17.3%

• Investment (ex-housing) – "Business Spending 12.7%

• Housing 3.8%

• Net Exports -2.9%

Consumer Spending (+)

Consumer spending which makes up 69.1% of our GDP should increase as a result of tax reform in 2018. In general, if people have more discretionary income, they will spend all or a portion of it. Tax reform will lower the tax bill, for not all, but many U.S. households, increasing their disposable income.  Also, if we see an increase in wage growth in 2018, people will be taking home more in their paychecks, allowing them to spend more.

Dr James Kelly, the chief economist of JP Morgan, made a very interesting observation about the evolution of the tax bill. When the tax bills were in their proposed state, one for the Senate and a separate bill for the House, each bill to stay under the $1.5 Trillion 10 year debt cap reduced taxes by about $150 Billion dollars per year. 50% of the annual tax reduction was going to businesses with the other 50% going to individual tax payers.

In order to get the bill passed before the end of the year, Congress was forced to shift a larger proportion of the $150 billion in tax brakes per year to individual taxpayers. In the tax bill’s final form, Dr Kelly estimated that approximately 75% of the tax reductions were now being retained by individual taxpayers with only 25% going to businesses. With a larger proportion of the tax breaks going to individual taxpayers that could increase the amount of discretionary income available to the U.S. consumer.

Government Spending (Push)

The anticipated increase in government spending really stems from the Trump agenda that has been communicated. One of the items that he campaigned on was increasing government spending on infrastructure. At this point we do not have many details as to when the infrastructure spending will begin or how much will be spent. Whatever ends up happening, we are not forecasting a dramatic increase or decrease in government spending in 2018.

Investment - Business Spending (+)

Even though business spending only represents 12.7% of our GDP, we could see a sizable increase in spending by businesses in 2018 for the following reasons:

• Corporate tax rate is reduced from 35% to 21%

• The repatriation tax will allow companies to bring cash back from overseas at a low tax rate

• Prior to tax reform, companies already had historically high levels of cash on their balance sheet. What are they going to do with more cash? (See the chart below)

If having more cash was not a large enough incentive by itself for companies to spend money, the new tax rules allowing immediate expensing of the full cost of most assets purchased for the next five years should be. Under the current tax rules, when a business purchases a new piece of equipment, a fleet of trucks, office furniture, whatever it is, the IRS does not allow them to deduct 100% of purchase price in the year that they buy it. They have to follow a "depreciation schedule" and they can only realize a piece of that expense each year. The current tax rules put companies at a tax disadvantage because companies are always trying to shelter as much income as possible from taxation. If Company XYZ buys a piece of equipment that cost $1,000,000, the IRS may require Company XYZ to depreciate that expense over a 10 year period. Meaning they can only realize $100,000 in expenses each year over that 10 year period, even though they already paid the full $1,000,000 for that new piece of equipment.Under the new tax reform, if Company XYZ buys that same new piece of equipment for $1,000,000, they can deduct the full $1,000,000 expense against their income in 2018. Whoa!!! That's huge!! Yes it is and it's a big incentive for companies to spend money over the next five years.

Housing & Net Exports (Push)

We do not expect any significant change from either of these two categories and they represent the smallest portion of our total GDP.

Watch GDP In 2018

The GDP growth rate in 2018 may give us the first indication as to how many "extra innings" we have left in this already long bull market rally. If we do not see a meaningful acceleration in the annual growth rate of GDP above its 2.2% average rate, the rally could be very short lived. On the flip side, if due to tax reform consumer spending and business spending leaps forward in 2018 and 2019, we may be witnessing the longest economic expansion of all time. Time will tell.

Share Buybacks

You will undoubtedly hear a lot about “Share Buybacks” in 2018. Remember, U.S. corporations will most likely have piles of cash on their balance sheets. Instead of spending that money on hiring new employees, buying new equipment, or building a new plant, what else might they do with the cash? The answer, share buybacks.

If a public company like Nike has extra cash, they can go into the market, purchase their own stock, and then get rid of those outstanding shares. Basically it increases the earnings per share for the remaining shareholders.

Example: Let’s assume there are only 4 shares of Nike owned by 4 different people and Nike is worth $100,000. That means that each shareholder is entitled to 25% of that $100,000 or $25,000 each. Now because of tax reform, Nike has $50,000 of extra cash just sitting in its coffers that it otherwise would have paid to the government in taxes. Nike can go into the market with $50,000, purchase 2 shares back from 2 of the shareholders (assuming they would be willing to sell), and then “retire” those two outstanding shares. After that is done, there are 2 outstanding shares remaining but the value of Nike did not change. So the two remaining shareholders, without paying anything extra, now own 50% of Nike, and their shares are worth $50,000 each.

Share buyback may push stock prices higher from a simple math standpoint. If the formula is the value of the company divided by the number of shares outstanding, the fewer shares there are, assuming the value of the company stays the same, the price per share will go up.   The incentive for these share buybacks will most likely be there in 2018. Not only will companies have the cash but share buybacks are a way that public companies can reward their current shareholders..

Is The Stock Market Too Expensive?

The P/E ratio of the S&P 500 Index is another barometer that investors will need to keep a close eye on in 2018. P/E ratios help us to answer the questions: “Is the stock market cheap, fairly valued, or expensive at this point?” The “Forward P/E Ratio” divides the price of a stock by the estimated future 12 months of earnings. The average Forward P/E ratio for the S&P 500 Index between December 1989 – September 30, 2017 was 16.0. As of December 22, 2017, the Forward P/E ratio of the S&P 500 Index is 19.99. In other words, it’s running at 25% above its 25 year historic average. See the chart below:

Conclusion, the U.S. stock market is not “cheap” and it’s a stretch to even classify it as “fairly valued”. I think we are well into what I would consider “expensive territory”. What does that mean for investors? You have to stay on your toes!!

Now, we have an anomaly in the mix with tax reform and history does not speak to how this could play out. If tax reform leads to an acceleration in corporate earnings, that in turn could slow the steady climb in the P/E ratio of the S&P 500 because earnings are the denominator in the formula. If stock prices and earnings are accelerating at the same pace, the stock market can go up without a further acceleration of the P/E ratio. Thus, keeping the stock market from becoming more overpriced and further increasing the risk of owning stocks in the S&P 500.

Summary

In 2018, investors should keep a close eye on the U.S. GDP growth rate, the level of spending by corporations and consumers, the volume of share buybacks by U.S. companies, and the P/E ratio of the S&P 500 Index.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Attention Middle Class: The End Is Near

I'm not a fan of conspiracy theories and I'm not a fan of "doom and gloom" articles. However, I feel compelled to write this article because I want people to be aware of a trend that is unfolding right now in our economy. This trend will strengthen over time, we will cheer for it as it's happening, but like many great things in history, it may have an unintended consequence. I fear that the unintended consequence of this new trend will be the elimination of the U.S. middle class.

More Profits

I’m an investment advisor so I naturally love a strong bull market that results in large investment gains for our clients. The stock market generally goes up when companies are more profitable than the consensus expects. Higher profits equal higher stock prices which equal more wealth for investors. Corporations have become laser-focused on findings new ways to increase profits. This is important because businesses that struggle to make profits and have constant losses are not so successful and will probably end up shutting down in the near future, according to websites like https://www.laraedo.com/signs-that-my-business-is-ripe-for-a-shutdown/. The equation for net profit is easy:

Revenue – Expenses = Net Profit

Let me ask you this question: What is typically a company’s largest expense?

Answer: Payroll. Said another way, the employees. Salaries, benefits, the building to house the employees, training, workers comp, payroll taxes, and the list goes on and on. If you are the owner of a company that makes cell phones and I told you that I have a way that you can make TWICE as many cell phones with HALF the number of employees, what do you think is going to happen to profits? Up!!! In a big way.

The scenario that I just described is not something that might happen in the future, it’s something that is happening right now. Here is the data to support it.

The chart below compares the 10 largest companies in the S&P 500 Index in 1990 to the 10 largest companies in the S&P 500 in 2016. First, you may notice that none of the companies that were the largest in 1990 remained on the list in 2016. But here is the trend that I want to point out. When you look at the 10 largest companies in 1990, they produced $368 Billion dollars of revenue and employed 1.4 Million workers. Fast forward to 2016, the top 10 largest companies produced $1.2 Trillion dollars in revenue and employed about 1.6 Million workers. Now let’s do some quick math, between 1990 and 2016 the gross revenue of the largest 10 companies in the S&P 500 increased by 239% but the number of workers employed by those companies only increased by 14%. Companies are already doing more with less people.

Just when you thought things were going good for the company, I now come to you, the owner of the company, and tell you I have a way to make profits double within the next 3 years. Are you interested? Of course you are. All we have to do is buy these three machines that will replace another 50% of the employees. These machines work 24 hours a day, don’t need health insurance, don’t get sick, and we can move to a smaller building which will reduce rent by 60%. How is that possible? Welcome to the party…..artificial intelligence.

Not A Terminator Movie

What do we think of when we hear the words “artificial intelligence”? Terminators!! Fortunately for us that’s not the artificial intelligence that I’m referring too. But a machine that thinks and learns from its mistakes? The human mind is not as unique as we would like to think it is. Just take a Myers Briggs personality test. You answer 100 questions and then it tells you how you react to things, what annoys you, what your strengths are, how you communicate, and what you have difficulties with. It’s kind of scary as you read the results and realize “Yup. That’s me”

Think about it. Google may know more about you than your spouse. What do you want for Christmas? Your spouse may not know but Google knows all of the items that you looked at over the past 3 months, what items you spent the most time looking at, did you click on the description to read more, and what other items did you look at after you click on the initial item. It tells Google how you search for information. Also Google acknowledges that we all search for things differently and what we are searching for tells Google more about us. Essentially Google learns at little bit more about you every time you search for something via their website.

What about a machine that can respond to questions and it sounds just like a person when it speaks? Oh and it speaks perfect English. No more overseas call centers with people you can’t understand. With most call centers, there are probably 20 questions that represent 80% of all the questions asked. If the machine is unable to answer the question, it automatically routes that call to a living, breathing person. The programmers of the machines are notified when a question triggers a transfer to a live person, they listen to the call, and then update the software to be able to answer the question the next time it is asked. The easy math, this could reduce the number of customer service representatives that the company needs to employ by 80%. Oh and the number of employees will continue to decrease as the machines learn to answer more questions and the software gets more sophisticated.

While a company may go this direction to reduce expenses, we as the consumer will also champion this change. Think about how painful it is to call the cable company. What if I told you that when you call you won’t have to wait on hold, the “person” that you are speaking to will know how to resolve your problem, and you will be off the phone in less than 2 minutes. Time is a valuable commodity to us. Fix my problem and fix it quickly. If a machine can do that better than a real person, be my guest. If companies want it and we as the consumer want it, how fast do you think it’s going to happen?

I Can't Be Replaced By A Machine.....Wrong

While we will cheer how the new A.I. technology saves us time and makes life easier, many of us will have the hubris that “a machine can’t do what I do?”. While a machine may not be able to replace 100% of what you do, could it replace 50%? It’s going to be presented like this, “you know all of those daily tasks that you don’t like to do: paperwork, scanning forms, payroll, and preparing financial reports for the weekly managers meeting. Well you don’t have to do those anymore.” Yes!!!! Oh and more good news you don’t have to train a new employee to complete those tasks and wonder if they are going to leave a year from now and have to train someone else.

Programming a machine to complete a task is not too different from training a new employee. When you hire a new employee many of them may know very little about your industry, they have no idea how your company operates, how to answer tough questions from prospects, etc. You have to train them or “program” them. Then they learn on the job from there. The value of having 20 years of experience is you have seen many difficult situations throughout your career and you learned from your past experiences. The next time the same or similar problem surfaces you know how to react. Normally what you do is you teach those lessons to each new manager and employee over and over again. That takes time. What if you only had to teach that lesson one more time and every new employee already knew how to react in the same tough situation? That’s artificial intelligence.

My point, this trend will not be limited to just manufacturing or customer services. This new technology will eventually impact each of our careers in some way, shape, or form.

3 Stages

I expect this to happen in three stages.

Stage 1: Companies do MORE with only a FEW MORE employees

Stage 2: Companies do MORE with the SAME number of employees

Stage 3: Companies do MORE with LESS employees

We are already through Stage 1 and we are entering Stage 2. How long will it be before we reach stage 3? That’s anyone’s guess. But with most evolution, Stage 1 takes the longest and the following stages evolve more rapidly. If Stage 1 took 16 years, my guess would be that stage 3 will be here a lot sooner than we think.

So What Happens To All Of The Employees?

The million dollar question and I don't know the answer. If I had to guess, the current middle class is going to be divided into two. Half of the middle class is going move up into the "upper class" and the other half will be "unemployed". The level of education will be the dividing line. Companies will continue to do more with less people. The only way to stop it is to tell companies that need to stop trying to be more profitable. Good luck. Our entire economy is built on the premise that you should accumulate as much as you can as fast as you can.

War and Conflict

When I look back in history, major conflicts arise when there is a large deviation between the “Have’s” and the “Have Not’s”. The fancy name that is used today is “income inequality”. When you have a robust middle class, everyone has something to lose if a conflict arises because that conflict generally disrupts the current system, uncertainty prevails, the economy goes into a recession, people lose their job, and they in turn cannot make their mortgage payment.

If instead, a majority of the population is unemployed and they can’t find a job because the jobs don’t exist anymore, that group of individuals has nothing to lose by burning the current system to the ground and rebuilding a new one from the ashes. I know that sounds dark but there is no arguing the gap between the Have’s and the Have Not’s is getting larger. Just look at the labor participation rate:

The Labor Participation Rate answers the question, how many people in the U.S. that could be working either are working or are looking for work? If there are individuals who could work, don’t have a job, and stop looking for work, they drop out of the labor force which decrease the labor participation rate because there are less citizens participating on the work force. As you can see in the chart above, in 2006 the labor participation rate was around 66%, and while we continue to experience one of the longest economic expansions of all time, the labor participation rate is still lower now than it was prior to the beginning of the economic recovery. Remember we are in an expansion and it has dropped by about 3%. What do you think will happen when we hit the next recession? While the baby boomer generation has had an impact on these numbers as you can see based on the large percentage of that decrease attributed to an “aging population”. Traditionally when someone retires, the company will promote the person below them and then hire another person to fill there spot. As many of us know, that’s not how it works anymore. Now that key employee retires, the company promotes one person into their role, but instead of hiring a new employee they just redistribute the work to the current staff. If anything, the baby boomer generation moving into retirement has made this transition to “do more with less people” easier on companies because they don’t have to fire anyone.

Tax Reform Will Accelerate The Trend

If you combine tax reform with the current 4.1% employment rate, I would expect this to accelerate the development of artificial intelligence. Companies are going to have cash from the tax savings to reinvest into new technologies which includes artificial intelligence. If the economy continues to grow at its current 2% pace or accelerates, one would expect consumption to increase which increases the demand for products and services. With the unemployment rate at 4.1%, we are already at "full employment". There are not enough qualified workers for companies to hire to meet the increase in demand for their product or service. The answer, let's accelerate the development of artificial intelligence that will allow the company to enter Phase 2 which is "Do MORE with the SAME number of workers".

People Will Cheer

These advances in technology are potentially setting the stage for levels of profitability that companies have only dreamed of. Higher profits traditionally equal higher stock prices. Investors will cheer this!! It may even lead us to the longest economic expansion of all time. In the short term, investors may have a lot to be excited about but we may look back years from now and realize that we were unintentionally cheering for the end of the middle class as we know it.

Again, this article is not meant to be a “dark cloud” or a new conspiracy theory but rather to keep our readers aware of the world that is changing rapidly around us. Like many of the economic challenges that the U.S. economy has experienced in the past, the hazard was in plain view, but investors failed to see it because they got caught up in the moment. When investing, it’s ok to take advantage of short term gains but never lose sight of the big picture.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

A Lesson From Bitcoin

I'm not writing this article to predict whether Bitcoin is going to $0 or $50,000. I have no idea whether it's going to go up or down from here. But I have had countless conversations with clients and friends over the past few weeks which starts like this "What do you think about Bitcoin?"

My response is, before you make any type of investment, you should be able to answer the following questions. If you can't answer these questions with confidence, you probably should not be investing in it.

"Explain It To Me In 30 Seconds"

Investing is as much of an art as it is a science which is why you can ask three different investment advisors about the same investment and get three different answers. While the full analysis of an investment can be complex and require a thorough understanding of markets, equity analysis, and financial reports, seasoned veterans have mastered their craft and have a way of simplifying the process. One of the lessons that I learned from my mentor and that I continue to apply to selecting investments today is "If you can't explain it to me in less than 30 seconds, I don't want to have anything to do with it."Before investing in anything, you should:

• Develop an investment thesis

• Identify the risks

• Identify competitors

• Know at what price to sell at

Let's look at each of these items and how they apply to the Bitcoin situation.

Develop an investment thesis

An investment thesis answers the question, why are you committing money to that particular investment? When buying a stock, you try to identify companies that have strong management, good cash flow, a promising new product or service, expanding market share, and a competitive advantage with the expectation that the company will outperform a given benchmark.

“Because I think it will go up” is not an investment thesis. You have to include in your investment thesis items that can be measured. If for example, I decide to invest in a cell phone company because they are expected to expand into China, India, and increase their market share over the next 3 years by 50%. I have identified a clear and measurable reason why I have chosen to invest in that company.

Bitcoin poses a challenge in this sense. When you invest in a company, you are essentially investing in the future cash flow that is expected to be produced by that company. Which is why the price to earnings ratio is often used to determine if a company is “reasonably priced”. Bitcoin is a currency that does not produce future cash flow so what metrics can you build into an investment thesis that will allow you to measure your expected outcome? I have yet to hear a good answer to that question. An “expert” making a prediction that Bitcoin is going to $30,000 is not a great metric to use. Remember, price appreciation is a by product of the improvement of the underlying financial drivers of an investment. If you can’t identify what those financial drivers are, price is irrelevant.

Identify the risks

Before making any investment, you should be able to take out a sheet of paper and list of the risks to your investment thesis. If you don’t know the risks, how do you know when to get out of that investment? In my cell phone company example, I bought that stock because I expected that company to gain 50% of the cell phone market share in China & India over the next 3 years. What are the risks to that investment thesis?

• Currency risk: The value of the U.S. dollar increases versus the local currency decreasing profits

• Execution risk: They do not successfully execute their strategy. It takes 5 years instead of 3.

• Political risk: The Chinese government assumes ownership of the company

• Market risk: The global economy goes into a recession

• Competitor risk: Another reputable cell phone company enters that market

• Management risk: The current CEO leaves the company and the new CEO takes the company in a different direction

• Cash flow risk: The company takes on too much debt trying to expand and has to scale back

While everyone goes into a new investment with the hopes and dreams that it is the next Apple, you have to be able to identify what could send your great investment tumbling to the ground.

Can you list all of the risks associated with Bitcoin? It could go to zero but that’s true of any investment. With many new technologies, services, currencies, and medical devices, you have too unfortunately accept the fact that all of the risks associated with that investment are probably not known. It does not necessarily mean it’s a bad investment since most breakthrough technology and products are met with resistance and then uniformly accepted by the masses down the road. But it does imply that the investment comes with a much higher level of risk because a greater number of unknowns exists and you have to be able to live with the fact that it has just as much of a chance of going up by 100% as it does going to zero. While this line of thinking may not completely deter you from making a particular investment, it will hopefully influence the amount that you decide to commit to riskier investments.

Identify Competitors

When identifying competitors, my first question is usually "how large are the barriers to entry into are particular product or market?" The larger the barriers to entry, the longer it takes competitors to catch up to the market leaders. It would seem in the case of Bitcoin, that the barriers to entry for cryptocurrencies are fairly low. I'm already starting to hear the buzz at holiday parties about "ICO's" which stands for Initial Coin Offering. If I were looking to invest in Bitcoin, I would be asking the questions:

• Who are the other main stream cryptocurrencies?

• Do they have a competitive advantage over Bitcoin?

• What would entice someone to switch from Bitcoin to another cryptocurrency?

• How large is the cyptocurrency market?

• Will regulations eventually come into play and create barriers to entry?

How many people that invested in Bitcoin do you think can answer these questions? My guess is not many. That in itself is risky.

Knowing At What Price To Sell

Of all the investment criteria that I have listed so far, I think this one is the most problematic when it comes to Bitcoin. When making any investment, you have to be able to answer the question: “Based on all of the information that I have today, at what price should I sell it at?” If I own a rental property and it’s fair market value is $250,000 and I collect $15,000 per year in rent, if someone offered me $300,000 to buy my rental property should I sell it? To answer that question, I would map out all of the income that I expect to receive from that property over my lifetime and apply a reasonable appreciation rate of the property value itself. It’s a similar process in evaluating a stock. You are looking at the annual earnings of the company and what you expect those earnings to be in the future. Both of these examples, like most investments, generate future cash flow and have reasonable appreciation rates that can be applied. With Bitcoin, as I mentioned earlier, there is no future cash flow. It’s value right now is being set based on what the next person is willing to buy it for. If one day people wake up and decide I don’t want to buy your Bitcoin or provide you with any good or services in exchange for your Bitcoin, there is nothing there. There are no earnings, there are no products, there are no services, there are no brick and mortar buildings, it’s vapor. With traditional currency, like the U.S. dollar, you have the taxing power and the assets of the United States government confirming that the dollar bill in your hand is worth something

So if I decide to buy Bitcoin today at $14,000 per coin, at what dollar amount should I sell it because it has become overvalued? I have no idea how anyone answers that question at this point. That’s problematic because if I start to make money, the difficult decision is “when do I get out?” When investing, it’s very easy to sell investments that have lost money. It’s emotionally much more difficult to sell your winners. So again, if I buy Bitcoin today and it goes to $30,000, do I sell it? Does it keep going to $50,000? I have absolutely nothing to based that on and that’s a problem.

Remember The Tulips

The single most important take away from this articles is "make sure you understand what you are investing in". If you can't explain it in less than 30 seconds, you probably should not be investing in it. Specific to Bitcoin, I use the saying, history does not repeat itself but it does rhyme. Some of the rhyming took place in the 1600's in the form of the Tulip bubble. In the Netherlands, during the Tulip mania, the cost of a tulip equaled to the cost of a house. Don't believe it? Just take a stroll down history lane. Here's the article: Tulip Mania

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Watch These Two Market Indicators

While a roaring economy typically rewards equity investors, the GDP growth rate in the U.S. has continued to grow at that same 2.2% pace that we have seen since the recovery began in March 2009. When you compare that to the GDP growth rates of past economic expansions, some may classify the current growth rate as “sub par”. As in the tale of the tortoise and the hare, sometimes slow and steady wins the race.

The number one questions on investor’s minds: “It’s been a great rally but are we close to the end?” Referencing the chart below, if you look at the length of the current economic expansion, going back to 1900 we are now witnessing the 3rd longest economic expansion on record which is making investors nervous because as we all know that markets work in cycles.

However, if you ignore the “length” of the rally for a moment and look at the “magnitude” of the rally it would seem that total GDP growth of the current economic expansion has been relatively tame compared to some of the economic recoveries in the past. See the chart below. The chart shows evidence that there have been economic rallies in the past that were shorter in duration but greater in magnitude. This may indicate that we still have further to go in the current economic expansion.

What causes big rallies to end?

Looking back at strong economic rallies in the past, the rallies did not die of old age but rather there was an event that triggered the next recession. So we have to be able identify trends within the economic data that would suggest that the economic expansion has ended and it will lead to the next recession.

Watch these two indicators

Two of the main indicators that we monitor to determine where we are in the current economic cycle are the Leading Indicators Index and the Yield Curve. History rarely repeats itself but it does rhyme. Look at the chart of the leading indicators index below. The leading indicators index is comprised of multiple economic indicators that are considered “forward looking”, like housing permits. If there are a lot of housing permits being issues, then demand for housing must be strong, and a strong housing market could lead to further economic growth. Look specifically at 2006. The leading indicators went negative in 2006, over a year before the stock market peaked in 2007. This indicator was telling us there was a problem before a majority of investors realized that we were on the doorstep of the recession.

Let’s look at the second key indicator, the yield curve. You will hear a lot about the “slope of the yield curve” in the media. In a healthy economy, long term interest rates are typically higher than short term rates which results in a “positively slopped” yield curve. In other words, when you go to the bank and you have the choice of buying a 2 year CD or a 10 year CD, you would expect to receive a higher interest rate on the 10 year CD because they are locking up your money for 10 years instead of 2.

There are periods of time where the interest rate on a 10 year government bond will drop below the interest rate on a 2 year government bond which is considered an “inverted yield curve”. Why does this happen and why would investors by that 10 year bond that is yielding less than the 2 year bond? This happens because bond investors are predicting an economic slowdown in the foreseeable future. They want to lock in the current 10 year interest rate knowing that if the economy goes into a recession that the Fed may begin to lower the Fed Funds Rate which has a more rapid impact on short term rates. It’s a bet that the 2 year bond rate will drop below the 10 year bond rate within the next few years.

If you look at the historical chart of the yield curve above, the yield curve inverted prior to the recession in the early 2000’s and prior to the 2008 recession.

Looking at where we sit today, within the last 6 months the leading indicators index has not only been positive but it’s accelerating and the yield curve is still positively sloped. While we realize that there is not a single indicator that accurately predicts the end of a market cycle, these particular economic indicators have historically been helpful in predicting danger ahead.

There will always be uncertainty in the world. Currently it has taken the form of U.S, politics, tax reforms, geopolitical events, and global monetary policy but it would seem that based on the hard economic data here in the U.S. that our economic expansion that began in March 2009 may still have further to go.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

The #1 Question To Ask Yourself Before Selling A Stock

When is the right time to sell an investment? It's a tough decision that individuals have a difficult time making but it's one of the most important decisions that you will have to make as an investor. Often time the decision to "buy" an investment is much easier.  You gather information on a given investment, look at the trends in the market acting on that investment, assess the risk versus reward trade off, and you put your strategy to work. Deciding to sell has a lot more emotions involved which frequently causes investors to make the wrong decision.

When do I sell a big winner?

First scenario is "the rocket ship". You purchased a stock and the stock price has gone through the roof. It's made you a ton of money on paper, you proudly boast to your friends and co-workers about the price that you bought it at, and in certain instances it has been a life changing financial event. The mistake investors make here is they get into what we call "the teddy bear syndrome".

Teddy bear syndrome.....

Have you ever tried to take a teddy bear away from a five year old......good luck. As adults, we often fall into the same behavioral pattern with very successful investments. Individuals typically have a strong emotional attachment to their most successful investments. But you will frequently hear many legendary investment managers make comments like: "Investment decisions are not emotional decisions. You have to remove your emotions from the decision-making process." Let's say you bought $10,000 of XYZ stock at $10 per share and five years later it's now selling at $890 per share turning your $10,000 into $890,000. Do you sell some of it, maybe all of it?

Here is the key question........

"If you had that $890,000 in cash in your hand today, would you invest all of it back into XYZ stock at $890 per share?"

Most people would say "No!! That's crazy. I would diversify that $890,000 across a number of holdings and the stock has already gone up so much". Continuing to hold a stock is the same decision as buying a stock. But doing nothing is easier because we feel like we are not making a decision, we are just "continuing to hold". Remember, it's easy to sell a stock that has lost money. It's much more difficult to sell a stock that produced a gain. Of course, this brings up the question of how do you find the right stocks to invest in?

"If I sell the stock, I'll have to pay tax on the gain."

Question: Would you rather pay taxes on a gain or lose money? Usually if you are paying taxes it means that you are making money. If I sold the stock holding in the example above, I would have an $880,000 long term capital gain at a minimum would pay around $132,000 in long term capital gains tax at 15%. This would leave me with $758,000 cash in hand from a $748,000 gain plus $10,000 original investment. What if instead of selling I continue to hold the stock and to no fault of company XYZ the economy goes into a recession? The stock goes from $890 a share to $500 a share. Now my total investment is worth $500,000 instead of $890,000. It's still a good investment because I bought it at $10,000 and it's still worth $500,000 but if I sold it at $500 per share I would still pay tax on the gain, now a smaller amount of gain, and be left with around $425,000. That poor decision cost me $333,000 after tax.

The fallen star

Most investors have been here at one point or another. You purchased a stock that rose in value dramatically but for whatever reason the stock lost all of its early investment gains and your investment is now underwater. Many investors will say “It’s a good long term holding so I’m just going to wait for it to come back.” While we are all familiar with the buy and hold strategy, there is a risk and opportunity cost with this strategy. The risk being that it may never come back to its original value. The opportunity cost is the money invested in that underperforming company could be growing somewhere else instead of just “waiting for it to come back”.

You must ask yourself the same key question that was listed above: “If I had that money in my hand today, would I invest all of it in that stock?” If the answer is “no”, you should probably sell some or all of it. Do not hold a stock solely based on a target share price. I will hear people say, “Well I bought it at $55 per share so I’m going to wait until it at least gets back to that price.” That is not an investment strategy. You must look at the fundamentals of the company, their competitors, global market conditions, company management, the company’s strategy, and their financials to really come up with a price target for the stock.

The inherited gem

It's a common occurrence that individuals will inherit stock from a family member and they know that family member had a strong emotional attachment to the stock because they either work for the company or they never sold a single share during their lifetime. It's easy to feel that selling the stock is in some way selling the memory of that family member. I will often hear comments like: "My dad worked for the company and held that stock for 40 years. He would be rolling in his grave right now if he knew I was thinking about selling his stock." This frequently happens because the generation before us had pension plans to support them in retirement and did not have to sell stock to supplement their income or they came from a generation that was very frugal about spending money. Your needs and circumstances are probably very different from the person that you inherited the stock from so you need to look at that investment holding from your financial standpoint.

I work for the company........

If you work for a publicly traded company then there is a good chance that you own shares of that company in an employee stock purchase plan, retirement plan, options plan, or brokerage account. Since you work for the company it usually means that you have "drank the kool-aide" and believe in the company's mission, vision, and you feel like you have more control over the fate of your investment. Remember, even though you work for that company it's still one company and attaching too much for your net worth to one investment is very risky. It's even more risky for employees because if something negatively impacts the company not only is your employment at risk but so is your total net worth if a large portion of your investment portfolio is tied to the company that you work for. Make sure you periodically calculate a total of all your investment holdings and compare that to the amount invested in your company's stocks to make sure you stay balanced in your overall investment approach.

Ask yourself the easy question.......

While making the decision to buy, sell, or hold an investment is not always an easy one. Finding the right answer may be as easy as asking yourself: "If the amount invested in that stock was in cash and in my hand today, would I invest 100% of it back into that stock holding?"

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Where Are We In The Market Cycle?

Before you can determine where you are going, you first have to know where you are now.  Seems like a simple concept.  A similar approach is taken when we are developing the investment strategy for our client portfolios.  The question more specifically that we are trying to answer is “where are we at in the market cycle?”  Is there more upside to the market?  Is there a downturn coming?  No one knows for sure and there is no single market indicator that has proven to be an accurate predicator of future market trends.  Instead, we have to collect data on multiple macroeconomic indicators and attempt to plot where we are in the current market cycle.   Here is a snapshot of where we are at now:

The length of the current bull market is starting to worry some investors. Living through the tech bubble and the 2008 recession, those were healthy reminders that markets do not always go up.  We are currently in the 87th month of the expansion which is the 4th longest on record.  Since 1900, the average economic expansion has lasted 46 months.  This leaves many investors questioning, “is the bull market rally about to end?”  We are actually less concerned about the “duration” of the expansion.  We prefer to look at the “magnitude” of the expansion.  This recovery has been different.  In most economic recoveries the market grows rapidly following a recession.  If you look at the magnitude of this expansion that started in the 4th quarter of 2007 versus previous expansions, it has been lackluster at best.  See the chart on the next page. This may lead investors to conclude that there is more to the current economic expansion.

Next up, employment.  Over the past 50 years, the unemployment rate has averaged 6.2%.  We are currently sitting at an unemployment rate of 5.0%.  Based on that number it may be reasonable to conclude that we are close to full employment.  Once you get close to full employment you begin to lose that surge in growth that the economy receives from adding 250,000+ jobs per month.  It may also imply that we are getting closer to the end of this market cycle.

Now let’s look at the valuation levels in the stock market.  In other words, in general are the stocks in the S&P 500 Index cheap to buy, fairly valued, or expensive to buy at this point?  We measure this by the forward price to earning ratio (P/E) of the S&P 500 index.   The average P/E of the S&P 500 over the last 25 years is 15.9.  Back in 2008, the P/E of the S&P 500 was around 9.0.  From a valuation standpoint, back in 2008, stocks were very cheap to buy.  When stocks are cheap, investors tend to hold them regardless of what’s happening in the global economy with the hopes that they will at least become “fairly valued” at some point in the future.  Right now the P/E Ratio of the S&P 500 Index is about 16.8 which is above the 15.9 historic average.  This may indicate that stock are starting to become “expensive” from a valuation standpoint and investors may be  tempted to sell positions during periods of volatility.

Even though stocks may be perceived as “overvalued” that does not necessarily mean they are not going to become more overvalued from here.  In fact, often times after long bull rallies “the plane will overshoot the runway”.  However, it does typically mean that big gains are harder to come by since a large amount of the future earnings expectations of the S&P 500 companies are already baked into the stock price.  It leaves the door open for more quarterly earning disappointments which could rise to higher levels of volatility in the markets.

The most popular question of the year goes to: “Trump or Hillary?  And how will the outcome impact the stock market?”  I try not to get too deep in the weeds of politics mainly because history has shown us that there is no clear evidence whether the economy fares better under a Republican president or a Democratic president. However, here is the key point.  Markets do not like uncertainty and one of the candidates that is running (I will let you guess which one) represents a tremendous amount of uncertainty regarding the actions that they may take if elected president of the United States.  Still, under these circumstances, it is very difficult to develop a sound investment strategy centered around political outcomes that may or may not happen.   We really have to “wait and see” in this case.

Let’s travel over the Atlantic.  Brexit was a shock to the stock market over the summer but the long term ramifications of the United Kingdom’s exit from the European Union is yet to be known.  The exit process will most likely take a number of years as the EU and the UK negotiate terms. In our view, this does not pose an immediate threat to the global economy but it will represent an ongoing element of uncertainty as the EU continues to restart sustainable economic growth in the region.

The chart below is one of the most important illustrations that allows us to gauge the overall level of risk that exists in the global economy.  When a country wants to jump start its economy it will often lower the reserve rate (similar to our Fed Funds Rate) in an effort to encourage lending.  An increase in borrowing hopefully leads to an increase in  consumer spending and economic growth.  Unfortunately, countries around the globed have taken this concept to an extreme level and have implemented “negative rates”.  If you buy a 10 year government bond in Germany or Japan, you are guaranteed to lose money over that 10 year period.  If you have a checking account at a bank in Japan, instead of receiving interest from the bank, the bank may charge you a fee to hold onto your own money.  Crazy right? It’s happening.  In fact, 33% of the countries around the world have a negative yield on their 10 year government bond. See the chart below.  When you look around the globe 71% of the countries have a 10 year government bond yield below 1%.   The U.S. 10 Year Treasury sits just above that at 1.7%.

So, what does that mean for the global economy?  Basically, countries around the world are starving for economic growth and everyone is trying to jump start their economy at the same time.  Possible outcomes?  On the positive side, the stage is set for growth.  There is “cheap money” and favorable interest rates at levels that we have never seen before in history.  Meaning a little growth could go a long ways.

On the negative side, these central banks around the global are pretty much out of ammunition.  They have fired every arrow that they have at this point to prevent their economy from contracting. If they cannot get their economy to grow and begin to normalize rates in the near future, when they get hit by the next recession they will have nothing to combat it with.   It’s like the fire department showing up to a house fire with no water in the truck.  The U.S. is not immune to this situation.  Everyone wants the Fed to either not raise rates or raise rates slowly for the fear of the negative impact that it may have on the stock market or the value of the dollar.  But would you rather take a little pain now or wait for the next recession to hit and have no way to stop the economy from contracting?   It seems like a risky game.

When we look at all of these economic factors as a whole it suggests to us that the  U.S. economy is continuing to grow but at a slower pace than a year ago.  The data leads us to believe that we may be entering the later stages of the recent bull market rally and that now is a prudent time to revisit the level of exposure to risk assets in our client portfolios.  At this point we are more concerned about entering a period of long term stagnation as opposed to a recession.  With the rate of economic growth slowing here in the U.S. and the rich valuations already baked into the stock market, we could be entering a period of muted returns from both the stock and bond market.   It is important that investors establish a realistic view of where we are in the economic cycle and adjust their return expectations accordingly.

As always, please feel free to contact me if you’d like to discuss your portfolio or our outlook for the economy.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Market Alert - UK Votes To Exit EU

We have been working through the night to monitor the UK exit vote in Europe and wanted to get this information out as soon as possible.Today is a historic day.  Last night the UK voted whether or not to leave the European Union.  The polls closed at 10 p.m. last night, the votes were counted, and at 2 a.m. this morning it was announced that the UK had voted 51.9% in favor of leaving the EU.  To put this situation in context, this would be similar to New York deciding to leave the United States to form its own country.

This was not the expected outcome and is largely an unprecedented event. Going into the vote yesterday most polls expected the UK “stay” vote to prevail given the economic headwinds that the UK would  face if the “leave” vote were to win.  David Cameron, the prime minister of the UK, was largely in favor of the UK staying in the EU.  Today at 3:30 a.m., Cameron announced that he would step down as the prime minister since new leadership, that is in favor of the exit, should be in place to negotiate Britain’s exit from the EU.

The European Union (EU) is made up of 28 countries.  It was originally formed back in 1957 with the goal of preventing wars and strengthening the economic bond between the European countries in its membership.  The UK joined the EU in 1973.  Members of the EU benefit from:

• Freedom of movement between countries

• Freedom of trade for goods, services, and capital

• EU human rights protection

• Euro currency (the UK does not participate in the euro currency)

The Argument To Stay In The EU

Supporters of the UK to stay in the EU believe that the Union is better for the British economy and that concerns about migration and other issues stemming from EU membership are not important enough to outweigh the economic consequences of leaving.  Many economists agree with this claim.  Europe is Britain’s most important export market and its greatest source of foreign direct investment.  An exit of the EU could jeopardize its financial status in the world and the high paying jobs that come with that status.

Those who voted to stay were not necessarily defending the EU but were basically arguing that the UK is stronger with the EU than without.

Argument To Leave The EU

Those in favor of the UK leaving the EU believe that leaving the European Union is necessary for the UK to restore the country’s identity.  Immigration has been one of the largest issue on the agenda with refugees entering the UK under the EU’s permission and “taking jobs” in the place of UK citizens.  Voters in the middle to lower income classes are viewed as more likely to support leaving the Union due to a feeling of being “abandoned by their country” in lieu of the EU policies.

In a way Britain feels like they used to matter to the world as an independent country but over the years have lost their identity now that they are lumped into the EU.  This group of individuals wants to be able to have full control over the country’s economic policy, culture, political system, and judicial system.

What Happens Next?

Now that the UK has voted to leave the EU, it has become clear that there needs to be new leadership in government that supports the UK exit since most of the current leaders, including the prime minister, were in favor of the UK staying in the EU.  We would expect this to happen in a fairly short period of time.

Once the new leadership is in place, the negotiation will begin between the UK and the EU for the exit.  There is not a precedence for this process which leaves a lot of unknowns.  Immediately, nothing changes.  Most likely while the negotiations are taking place over the course of next few months, or more likely years since the UK is still technically an EU member, UK citizens will still be able to move about the Eurozone countries freely, trade will continue, etc.

However, there will most likely be an immediate negative impact on the UK economy given the expectation of the exit.  The British pound (currency) will most likely drop significantly.  The profitability of the multinational companies and banks that are headquartered in the UK will come into question since they will eventually lose the benefits of free trade and capital movements with other EU countries.

Overall we are entering a period of increased uncertainty. Unfortunately, in our view, there is a larger issue at hand.  Yes, the UK exiting the EU is a significant event but the larger issue is for the first time they are laying the ground work that will allow a country to exit the EU.  There are other countries in the EU that may take up similar votes to leave the European Union since a precedence is now being set for the UK to exit.  If the entire EU were to further destabilize it would most likely cause further disruption across the global economy. 

Michael Ruger

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

What is a Bond?

What is a Bond?

A bond is a form of debt in which an investor serves as the lender.  Think of a bond as a type of loan that a company or government would obtain from a bank but in this case the investor is serving as the bank.  The issuer of the bond is typically looking to generate cash for a specific use such as general operations, a specific project, and staying current or paying off other debt.

How do Investors Make Money on a Bond?

Your typical bonds will generate income for investors in one of two ways:  periodic interest payments or purchasing the bond at a discount.  There are also bonds where a combination of the two are applicable but we will explain each separately.

Interest Payments

There are interest rates associated with the bonds and interest payments are made periodically to the investor (i.e. semi-annual).  When the bonds are issued, a promise to pay the interest over the life of the bond as well as the principal when the bond becomes due is made to the investor.  For example, a $10,000 bond with a 5% interest rate would pay the investor $500 annually ($250 semi-annually).  Typically tax would be due on the interest each year and when the bond comes due, the principal would be paid tax free as a return of cash basis.

Purchasing at a Discount

Another way to earn money on a bond would be to purchase the bond at a discount and at some time in the future get paid the face value of the bond.  A simple example would be the purchase of a 10 year, $10,000 bond for a discounted price of $9,000.  10 years from the date of the purchase the investor would receive $10,000 (a $1,000 gain).  Typically, the investor would be required to recognize $100 of income per year as “Original Issue Discount” (OID).  At the end of the 10 year period, the gain will be recognized and the $10,000 would be paid but only $100, not $1,000, will have to be recognized as income in the final year.

Is There Risk in Bonds?

Investment grade bonds are often used to make a portfolio more conservative and less volatile.  If an investor is less risk oriented or approaching retirement/in retirement they would be more likely to have a portfolio with a higher allocation to bonds than a young investor willing to take risk.  This is due to the volatility in the stock market and impact a down market has on an account close to or in the distribution phase.

That being said, there are risks associated with bonds.

Interest Rate Risk – in an environment of rising interest rates, the value of a bond held by an investor will decline.  If I purchased a 10 year bond two years ago with a 5% interest rate, that bond will lose value if an investor can purchase a bond with the same level of risk at a higher interest rate today.  This will make the bond you hold less valuable and therefore will earn less if the bond is sold prior to maturity.  If the bond is held to maturity it will earn the stated interest rate and will pay the investor face value but there is an opportunity cost with holding that bond if there are similar bonds available at higher interest rates.

Default Risk – most relevant with high risk bonds, default risk is the risk that the issuer will not be able to pay the face value of the bond.  This is the same as someone defaulting on a loan.  A bond held by an investor is only as good as the ability of the issuer to pay back the amount promised.

Call Risk – often times there are call features with a bond that will allow the issuer to pay off the bond earlier than the maturity date.  In a declining interest rate environment, an issuer may issue new bonds at a lower interest rate and use the profits to pay off other outstanding bonds at higher interest rates.  This would negatively impact the investor because if they were receiving 5% from a bond that gets called, they would likely use the proceeds to reinvest in a bond paying a lower rate or accept more risk to earn the same interest rate as the called bond.

Inflation Risk – a high inflation rate environment will negatively impact a bond because it is likely a time of rising interest rates and the purchasing power of the revenue earned on the bond will decline.  For example, if an investor purchases a bond with a 3% interest rate but inflation is increasing at 5% the purchasing power of the return on that bond is eroded.

Below is a chart showing the risk spectrum of investing between asset classes and gives a visual on the different classes of bonds and their most susceptible risks.

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Types of Bonds

Federal Government

Bonds issued by the federal government are backed by the full faith and credit of the U.S. Government and therefore are often referred to as “risk-free”.  There are always risks associated with investing but in this case “risk-free” is referring to the idea that the U.S. Government is not likely to default on a bond and therefore the investor has a high likelihood of being paid the face value of the bond if held to maturity but like any investment there is risk.

There are a number of different federal bonds known as Treasuries and below we will touch on the more common:

Treasuries – Sold via auction in $1,000 increments.  An investor will purchase the bond at a price below the face value and be paid the face value when the bond matures.  You can bid on these bonds directly through www.treasurydirect.gov, or you can purchase the bonds through a broker or bank.

Treasury Bills – Short term investments sold in $1,000 increments.  T-Bills are purchased at a discount with the promise to be paid the face value at maturity.  These bonds have a period of less than a year and therefore, in a normal market environment, rates will be less than those of longer term bonds.

Treasury Notes – Sold in $1,000 increments and have terms of 2, 5, and 10 years.  Treasury notes are often purchased at a discount and pay interest semi-annually.  The 10 year Treasury note is most often used to discuss the U.S. government bond market and analyze the markets take on longer term macroeconomic trends.

Treasury Bonds – Similar to Treasury Notes but have periods of 30 years.

Treasury Inflation-Protected Securities (TIPS) – Sold in 5, 10, and 20 year terms.  Not only will TIPS pay periodic interest, the face value of the bond will also increase with inflation each year.  The increase in face value will be taxable income each year even though the principal is not paid until maturity.  Interest rates on TIPS are usually lower than bonds with like terms because of the inflation protection.

Savings Bonds – There are two types of savings bonds still being issued, Series EE and Series I.  The biggest difference between the two is that Series EE bonds have a fixed interest rate while Series I bonds have a fixed interest rate as well as a variable interest rate component.  Savings bonds are purchased at a discount and accrue interest monthly.  Typically these bonds mature in 20 years but can be cashed early and the cash basis plus accrued interest at the time of sale will be paid to the investor.

Municipal Bonds (Munis) – Bonds issued by states, cities, and local governments to fund specific projects.  These bonds are exempt from federal tax and depending on where you live and where the bond was issued they may be tax free at the state level as well.  There are two categories of Munis: Government Obligation Bonds and Revenue Bonds.  Government Obligation Bonds are secured by the full faith and credit of the issuer’s taxing power (property/income/other).  These bonds must be approved by voters.  Revenue Bonds are secured by the revenues derived from specific activities the bonds were used to finance.  These can be revenues from activities such as tolls, parking garages, or sports arenas.

Agency Bonds – These bonds are issued by government sponsored enterprises such as the Federal Home Loan Mortgage Association (Freddie Mac), the Federal Home Loan Mortgage Association (Fannie Mae), and the Federal Agricultural Mortgage Corporation (Farmer Mac).  Agency bonds are used to stimulate activity such as increasing home ownership or agriculture production.  Although they are not backed by the full faith and credit of the U.S. Government, they are viewed as less risky than corporate bonds.

Corporate Bonds – These bonds are issued by companies and although viewed as more risky than government bonds, the level of risk depends on the company issuing the bond.  Bonds issued by a company like GE or Cisco may be viewed by investors as less of a default risk than a start-up company or company that operates in a volatile industry.  The level of risk with the bond is directly related to the interest rate of the bond.  Generally, the riskier the bond the higher the interest rate. 

About Rob……...

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.