The sharp market selloff in the fourth quarter of last year was partially caused by investor concern over an inverted yield curve. Just last week we saw another big drop as the curve inverted again. What is the yield curve and why are people worried about it? More importantly, how could it affect your plans if you’re at or near retirement and what can you do to protect yourself?
What is the yield curve?
When you get a loan, the interest rate you pay is based (in part) on how long you need to borrow the money. All else being equal, the longer you borrow, the higher the interest rate will be. The same is true when the government borrows. They pay higher interest on 30-year bonds than on 30-day bonds. If you plot out government bond rates (e.g. 1-year, 2-year, 5-year, etc.) and connect them with a line, that is the yield curve. In a normal economy, the curve slopes up and to the right, because as we just discussed, rates rise along with time to maturity.
Why is everyone worried about it?
As we just saw, a normal yield curve slopes up and to the right because long-term rates are typically higher than short-term rates. Once in a while, however, conditions are such that short-term rates rise above long-term rates. This is a warning sign that the markets are anticipating trouble for the economy and they expect the Federal Reserve to cut rates. When short-term rates rise above long-term rates, that graph we talked about earlier shifts from upward sloping to downward sloping. In short, it becomes inverted. This is concerning, because it turns out that an inverted yield curve is a pretty good predictor of recession.
Does an inverted curve guarantee a recession?
Not every inverted yield curve has led to a recession, but every recession we’ve had since World War II has been preceded by an inverted yield curve. So when the yield curve inverts, it’s worth paying attention to.
Is the yield curve inverted now?
The yield curve flattened for most of 2018 as the Fed raised short term interest rates and long-term rates stayed low. Then, during the fourth quarter, portions of the yield curve inverted. It wasn’t entirely inverted, but even having portions inverted is a red flag. Rates normalized a bit earlier this year (and the markets rallied), but last week portions of the curve inverted again when 10-year rates fell below 3-month rates.
If a recession follows an inversion, how long does it usually take?
An inverted curve is a good predictor of recessions, but they generally don’t happen right away. The average time between inversion and recession is about a year.
What does the stock market typically do after the curve inverts?
Markets will usually continue to rise for a period of time after an inversion. For example, markets rose an average of 35% after the last 3 inversions (1989, 1998 and 2006), before ultimately falling as the economy went into recession. And returns on the S&P tend to be above average for many months after an inversion. So yes, an inverted yield curve can signal a potential recession, but it can also signal a period of strong stock returns before the recession arrives.
What should investors be doing?
A yield curve inversion isn’t a perfect indicator and it’s by no means the only economic indicator. There are plenty of signs that point to a strong U.S. economy and as we saw above, markets usually continue to rise for a period of time even after an inversion. That said, it’s a red flag, as are signs of slowing economic activity in Europe and China. The best thing you can do is to make sure that you are invested in a way that is consistent with your risk tolerance, time to retirement, goals and overall financial situation. Then, even if things get choppy, you’ll be able to ride out the storm. For further ideas on what to do, read: Should you prepare for a deeper downturn?
What are you afraid of? Be honest. We all have stuff that scares us. Maybe it’s something big. Maybe small. Regardless of what it is, the outcome is often the same: Stasis. Fear acts as a roadblock that keeps us from doing something. Fear is often the great preserver of the status quo. It keeps you from having that uncomfortable conversation with your spouse or friend. It keeps you from going to the doctor. Or asking for a raise. Or joining the gym. Or dealing with an addiction. Or moving to a new town. Or changing jobs. Or starting a business. Or making new friends. Or traveling. These fears, big and small, stop us in our tracks and the longer we allow them to persist, the more insurmountable they seem.
But here’s the thing. Almost every fear that you and I have—those things that have been holding us back for years and that are keeping us from the things that we genuinely want from life—can be overcome with a few seconds of uncomfortable action. It reminds me of that quote from Matt Damon’s character in the movie We Bought a Zoo:
“Sometimes all you need is 20 seconds of insane courage. Just literally 20 seconds of embarrassing bravery and I promise you something great will come of it.”
This is true because fear isn’t something that persists for very long in the face of action. Once you start, the fear subsides and you focus on the action at hand. In that sense, inaction is much more uncomfortable than action because the fear and anxiety of inaction is a long-term state. We marinate in it, sometimes for years. Once you start, however, and push through the fear with a short burst of bravery, the fear subsides and your focus shifts to whatever it is that you’re doing.
I’m writing about this idea because I’ve had constant reminders about it on this trip. When traveling, especially internationally, there are dozens of little fears that crop up. Not being able to speak the language. Driving a rental car in a strange city. Figuring out the subway. Those things can make you want to curl up in a ball in your hotel room and cry. Fortunately, inaction isn’t really a choice. Scared of driving? Too bad. You’ve got 100 cars behind you. Subway make you nervous? Unless you want to sleep at the airport, you’d better take a stab at it. So you do. And…hey…what do you know! You figure it out. Maybe you didn’t do it perfectly, but you survived. You learned something and built a bit of confidence that you can keep in your back pocket for the next challenge. More importantly, fear vanquished, you get to do the thing that you’ve been wanting to do. String a bunch of those together and you have a life that is rewarding and untarnished by regret.
So I’ll ask again: What are you afraid of? Whatever it is, you have a choice. You can let it fester and keep you from the life you want or you can muster 20 seconds of bravery and take the first step toward resolution. Choose the former and you’ll likely be miserable. Choose the latter and you’ll wonder why you didn’t do it sooner. Good things are just on the other side of an impermanent barrier that can be breached with a few seconds of bravery. What are you waiting for?
“Do not be too timid and squeamish about your actions. All life is an experiment. The more experiments you make the better. What if they are a little coarse and you may get your coat soiled or torn? What if you do fail, and get fairly rolled in the dirt once or twice? Up again, you shall never be so afraid of a tumble.” ― Ralph Waldo Emerson
I wrapped up my time in France yesterday and hopped an early morning flight to Naples, Italy. From there I came to a little seaside town on the Amalfi Coast called Positano. I’ve got four days here with a few concentrated on work and a few for activities (e.g. visiting Pompei and Vesuvius, hiking the Sentiero degli Dei (Path of the Gods), etc.). I’ll get a post up soon filling you in on my time in France. Thanks for following along!
Every year the flu kills about 36,000 people in the United States. Those who die typically have an immune system that is already compromised in some way, such as by age or illness. In other words, it’s not necessarily the strength of the flu that is so dangerous, but the weakness of some immune systems.
In the same way that the flu virus can disproportionately affect those with weakened immune systems, a financial virus can disproportionately affect those with compromised financial health. The virus could be something as simple as an unexpected car repair or something a bit more serious like a market crash, job loss, divorce, disability, illness or unexpected death. How well you’re able to respond to those things depends on how financially healthy you are and how well you’ve immunized yourself against those threats.
Some people are fragile and at risk. Others are financially resilient. The closer you get to retirement, the more resilient you want to be so that something unexpected doesn’t derail decades of planning. Below are five things that, financially speaking, will either make you weak or strong, depending on how you handle them.
How much you owe. There are many tell-tale signs of a person who is financially fragile and having too much debt is often the most obvious. When you take on debt, you are bringing future consumption to the present. That gives creditors a legal claim on your future earnings, which reduces your cash flow, increases the risk that you will run out of money and limits what you can afford to do. Get rid of your debt, however, and not only will you be more financially resilient, but you can also retire sooner. Unfortunately, years of low interest rates have encouraged exactly the opposite behavior. What’s a good level of debt for a retiree? Shoot for zero.
How much you spend. If you live at or above your means, you are financially fragile. That’s true whether you make $50,000 per year of $500,000. Here’s the good news. Most of the people reading this likely have the ability to live significantly below their means. What if you spent 10% to 50% less than you made every year? Would that give you a certain resilience? You wouldn’t be worried about an unexpected car repair, I can tell you that much. So take a stand against lifestyle inflation. Just because you will earn more money this year than you did last year doesn’t mean you have to spend it. Set a lifestyle cap and save the rest.
How much you’ve saved. If you spend less than you make, you’re able to save. That savings not only protects you in the short term (i.e. emergency fund), but it allows you the financial freedom to live the life you want to live in the long run (i.e. retirement). In other words, savings is the secret sauce in both security and independence. How much should you have saved by now? This article will give you a rough idea.
How well you’ve planned. Most people don’t have a plan for retirement. They don’t know what they want to do, how much it will cost or whether or not they are on track to save enough to pay for it. Not surprisingly, that creates a great deal of anxiety, uncertainty and—you guessed it—financial frailty. If you are among the 88% of people who don’t have a written plan, your retirement will probably fall far short of what it could be.
A plan can also help inoculate you against bad decisions. Sometimes a financial virus takes the form of fear and uncertainty. When we’re scared, we tend to make unwise and irrational decisions. To navigate those waters, it’s good to have a North Star. The wind can blow and the seas can rage, but when you look up, it will be there. A detailed retirement plan can act as that North Star. If you have a long-term plan—you know where you are, where you want to be and how you’re going to get there—you can inoculate yourself against short-term fear and uncertainty. When you have context and you understand the big picture, you’re less likely to be blown off course or panic and make a mistake. For help with creating a plan, check out my Ideal Retirement Design Guide or touch base with me if you want some one-on-one help.
How well you’ve prepared for the unexpected. What if something happened to you or your spouse? Would that derail your finances? Are your legal and financial affairs in order? Life is unexpected. The more “What if?” planning you do, the more resilient you will be in the face of tragedy. Here are two articles and a guide that can help:
That’s five ways to boost your immunity, harden your defenses and make yourself more financially resilient. But they only work if you take action. Modern medicine has given us many miracle vaccines, but they only work if you take them. So too, financial vaccines are either contagion or cure, depending on what you do with them.
The current bull market is 9 years old. That’s the second longest on record and it has people wondering how much further it can go. That question has taken on added urgency given the recent volatility, rising interest rates and political uncertainty. Markets lost ground in February (the first losing month in over a year) and they’re on track to close lower in March as well. Is this the beginning of something bigger? Should you make changes to your portfolio or otherwise prepare for a deeper downturn? I’ll share my thoughts below.
Keep Things in Perspective
First of all, I think it’s good to keep things in perspective. Yes, there have been some scary drops recently. In February, the Dow had its two biggest point drops ever. The S&P 500 had four of its largest drops ever. On a percentage basis, however, those drops didn’t even crack the top 20. Still, when the daily loss has a comma, it’s disconcerting. Just try to remember that pullbacks are natural and healthy, especially after the outsized gains we’ve had over the last several years. At the beginning of this bull market (the end of the Great Recession) the Dow was below 7,000 and the S&P was below 700. Now, even after the recent selling, they’re around 24,000 and 2,600 respectively.
Watch the Fundamentals
Warren Buffett has famously said that in the short-term the market is a voting machine, but in the long-term it’s a weighing machine. In other words, fundamentals matter more than feelings. How do the fundamentals look? In a word, strong. GDP and corporate earnings are growing at the fastest pace in years. The tax cuts will boost profits even more. Job creation continues to surprise on the upside. Unemployment is low. Consumer sentiment and consumer spending are very strong. Interest rates are still relatively low. Most signs point to a healthy and growing economy.
3 Key Risks
While most indicators are positive, that doesn’t mean that investors should be complacent. The bullish case is always strongest right before it’s not. And even if the fundamentals stay strong, you can still get some nasty price corrections. What are the key risks?
I see three primary risks right now: 1) Valuations, 2) Interest Rates, and 3) Political/Geopolitical risks. Because of the strong economy, stocks have been going up and valuations are at the upper end of their historical range. Markets are priced for perfection. What if we don’t get it? To quote John Mauldin, an economist I follow, “the consequences of a mistake are growing.” Or what if the Fed raises rates too aggressively? That could tip the economy into recession. And the uncertainty in Washington is not helping. If we get into a trade war with China or the Mueller investigation finds serious wrongdoing, markets will not react positively.
How to Protect Yourself
I said earlier that pullbacks are healthy. What do I mean by that? Economist Hyman Minsky had a theory that stability leads to instability. In other words, when the economy and markets are good, it encourages more and more risk taking. People start to focus on reward and ignoring risk. They invest too aggressively. They take on too much debt. They save less. They get complacent. And then a shock hits the system, losses start to build and people panic. The bottom falls out. That sudden instability is referred to as a Minsky Moment. The longer the period of stability, the greater the likelihood that people are making decisions that will eventually lead to serious instability. Periodic corrections are healthy because they keep people from straying too far from home.
Which brings me to the question at the beginning of this article. Should you prepare for a deeper downturn? The answer, of course, depends. During this 9-year bull market, how far have you strayed or drifted from your appropriate investment and retirement strategy? How can you tell? Here are 7 areas to look at closely.
Risk Tolerance. The longer a bull market goes, the less people worry about (or even think about) risk. That’s a problem, because the economy and markets usually revert to the mean. What would mean reversion look like now? We’ve gotten a taste of it over the last several weeks. After years of rising markets, they start to fall. After years of almost non-existent volatility, it spikes. After a decade of historically low interest rates, they start to climb. If the market dropped 20-30% this year, how would that impact your portfolio? Could you (would you) just ride it out? If not, you should probably dial back your risk.
Asset Allocation. The two primary ways to manage risk are through diversification and asset allocation. Look at your portfolio. Do you have any outsized positions? Is your stock/bond balance appropriate given your risk tolerance? Has your allocation drifted or changed over the years? Review your portfolio and align your asset allocation with your risk tolerance.
Time Horizon. All of this is a bigger deal if you’re at or near retirement. You have less to worry about the longer you have to go. Even after the 57% peak to trough drop in 2008-09 the markets fully recovered within about 4 years. Those who rode it out did fine. Could you ride out another major downturn? If you’re already retired, maybe not. At the very least you’re 9 years closer to retirement than you were during the last serious pullback. And even if you have time, sharp drops can cause you to make mistakes and do the wrong thing at the wrong time, so see points 1 and 2 again. Make sure you understand your risk tolerance and that your allocation is aligned with that.
Spending. Most people have lifestyle bloat as they get older. As income grows, so do expenses. Bigger paychecks mean better houses, cars, vacations, wardrobes and gadgets. That’s not necessarily bad, but the longer good times persist, the closer we tend to push our spending to the outer limits. That makes a person financially fragile. It can cause stress, limit your options and force you to make compromises in life. You control your spending. Beware of bloat. The more you live below your means, the more financially resilient you will be. And when you splurge on things or add expenses, do your best to make that spending discretionary rather than fixed. That way you can dial back if your income drops or the economy heads into recession. See this article on how to use dynamic spending to make your money last.
Debt. One of the characteristics of long bull markets is that people load up on debt. The boom years make them more comfortable borrowing for cars, houses and credit cards. Having debt adds risk and reduces cash flow, two things that are especially troublesome for a person at or near retirement. If you want to be better positioned to weather a financial storm, get rid of debt.
Saving. The average savings rate in 2015 was 7.19%. In 2016 it fell to 5.98%. Last year it fell to 3.74%. Care to guess which direction it will move in 2018? This is what Minsky was talking about. Stability leads to instability. People become complacent. They save less, which means they have less of a buffer, which means they’re less able to weather a storm.
Cash. It’s always a good idea to have a portion of your portfolio in cash or short-term securities. That way, if markets drop and a good investment opportunity presents itself, you’ll have some dry powder to invest. Or, if you’re already retired and taking distributions from your portfolio, you can pull your distributions from your cash rather than selling your stocks into a declining market.
Will the markets drop further? Who knows. The risk is certainly there. The important thing is to focus on the things you can control and make sure that if we get another downturn, it won’t derail your plans.
The amount of debt in the world is staggering.
- Auto loans recently passed $1 trillion for the first time and the average car loan is the highest it’s ever been, recently surpassing $30,000.
- Student debt stands at about $1.4 trillion.
- Mortgage debt is about $14 trillion.
- More than 30% of households carry a balance on their credit cards. Those that do have an average balance of $16,000
- The top 2,000 non-financial companies have $6.64 trillion in debt, $2.81 trillion of which they’ve added in the last five years.
- The U.S. public debt has nearly doubled since the 2008 financial crisis, ballooning from $10 trillion to more than $19 trillion.
- 20 years ago China had $500 billion in public and private and debt. Ten years ago that number stood at $3.5 trillion. Today it is more than $35 trillion.
More than the amount of debt, however, is just how much of it has been added since the 2008 financial crisis. After experiencing a debt induced financial Armageddon, you’d think individuals, companies and governments would be hesitant to go down that road again. Not so. Record low rates have fueled trillions (with a “T” like the Titanic) in new debt. It’s like eating until you’re sick at a buffet and then deciding that the next logical step is to grab a new plate and see how many cheese enchiladas and Mini BBQ Brisket sandwiches you can fit on it.
And just like binging at the buffet is likely to end badly, binging on debt will usually end in a combination of regret and real world consequences. How is all this debt affecting us and our ability to reach our retirement goals?
It’s causing stress. A recent survey of adults with student loan debt showed that people would go to some pretty extreme lengths to get rid of that debt. Nearly 57% would take a punch from Mike Tyson. More than 40% would give up a year of life expectancy. Almost 7% said they’d be willing to cut off their own pinky finger. Think about that. A not insignificant percentage of the borrowers polled would be willing to die sooner or hack off body parts if they could turn back time and get out from under their debt. Living with excessive debt is stressful.
It’s making us financially fragile. A recent Federal Reserve survey found that 47% of Americans could not cover an unexpected $400 expense without borrowing or selling something. In other words, half the country is stretched so thin that they couldn’t afford a car repair or a new pair of glasses without some sort of payment plan. There are likely many reasons for this state of affairs, but one is most assuredly debt. In other words, we need to go into debt to fund new purchases because all of our income is already being used to pay for the debts from our old purchases.
It’s limiting our ability to save for retirement. Each year the Employee Benefits Research Institute (EBRI) conducts a Retirement Confidence Survey to see how people are doing when it comes to saving for retirement. In the most recent survey, nearly a third of respondents reported having less than $1,000 saved so far. Two-thirds have less than $50,000 saved. You don’t need to be a financial genius to know that $1,000 is not enough to fund a 20 or 30 year retirement. Even $50,000 would only get you a year or two at best. Why aren’t we saving more? Again, one reason is debt. If most of your current money is being used to pay for past purchases, you won’t have much left over for future savings.
It’s exposing retirees to market risk. Even if you are near retirement and you have no debt, you may still be at risk from debt indirectly. That’s because, with interest rates so low, many retirees have been forced to move further up the risk spectrum to get any sort of yield on their investments. It used to be that you could put your money in a risk-free money market and earn 3%. Now those same investments pay 0%. Super safe bonds don’t yield much better, so many investors are shifting more of their portfolio to lower quality bonds or dividend paying stocks. That works fine while markets are rising, but if we get another debt shock and borrowers can’t repay, then markets could tumble and many investors may find that they took on too much risk in their search for yield.
How much debt is ok?
To be sure, not all debt is bad. Debt can be a useful tool when it’s used to purchase an asset or invest in a project that helps us to generate income and pay back the debt. That said, in order to retire comfortably, the typical person needs to move from a place of low savings and high debt early in their career to a place of high savings and low debt later in their career.
What should that gradual reduction look like? To help people track their progress, researcher Charles Farrell devised a Debt to Income Ratio and then established benchmarks for different age groups. According to Farrell, your debt (e.g. mortgage, car loans, credit cards, etc.) divided by your income should be 1.25 at 40, .75 at 50, .20 at 60 and zero at retirement.
Retiring debt free used to be the rule rather than the exception. Unfortunately, that is no longer the case. In fact, a recent study by the Employee Benefits Research Institute showed that 65 percent of American families with a head of household age 65-74 had debt. The age group with one of the biggest spikes in debt was 75 and older.
That’s troubling because debt adds risk and reduces cash flow, two things that can derail your retirement. It is inherently limiting at a time when most hope for greater independence and opportunity. It increases uncertainty at a time when most people want security. So make a plan to gradually eliminate your debt and you will greatly increase your odds of having freedom, flexibility and peace of mind during retirement.
“What could cause this to fail?”
That’s what I asked myself before heading to the Grand Canyon recently for a 47 mile, Rim to Rim to Rim hike with my friend Mike. The answer, it turns out, is “A LOT of things could cause it to fail.” In fact, there’s a 400 page book dedicated solely to detailing all of the deaths that have occurred in the canyon in modern times. I know because I read it. I wanted to see all the dumb, misguided, or sometimes just unlucky decisions people made that ended very badly so I could avoid those same blunders. I like adventure as much as the next guy, but priority #1 is coming home alive. Hence my question: What could go wrong and how can I avoid it? I call this process a Pre-Mortem.
You’ve likely heard of a Post Mortem. When someone dies, the medical examiner will often do a Post Mortem exam to determine cause of death. Similarly, when a project fails at work, the team responsible for said failure will often do a project Post Mortem to determine what went wrong. Post mortems can be helpful because people can learn from them and lessons can be used to avoid future mistakes.
The downside of a Post Mortem is the Post (after) part. Whatever it is you’re examining has already gone horribly wrong and the game is over. The opportunity is gone. Others can learn from your mistakes, but your chance is gone.
A better thing to do would be to do a Pre-Mortem. Instead of “Why did this fail?” ask yourself “What might cause this to fail?” Look at your own weak points and vulnerabilities. Examine other people who have failed doing something similar. What can you learn from them? How can you avoid similar mistakes or pitfalls?
The application to retirement is obvious. Retirement is a relatively short period of time when you hope to live a secure, exciting and fulfilling life. The problem is you’ve only got one shot at it and there are a whole mess of variables, any one of which could derail your plans. By doing a Pre-Mortem, you examine your unique situation and consider the most probable things that could cause your retirement to get sideways. Then you do everything you can to plan and prepare so those things either don’t happen or you’re well equipped to deal with them if they do. Result: Retirement goes off without a hitch.
What are some of the more common things that derail retirement?
- Running out of money
- Death of a spouse
- Health issues with you or a spouse
- No clear plans for what you want to do
- Lack of friends
- Depression/anxiety due to major life change
- Market crash
- Unexpected job loss
- Family issues (children, relative, etc.)
- Caring for elderly parents
- Living longer than you expected
- High debt or other poor financial decisions
- Health care costs
- Mistakes claiming Social Security
- Mistakes with your distribution strategy
Which are the most likely to trip up your plans? Think honestly about your life, your finances, your health, your family and your friendships. What things do you honestly see as the biggest potential threats to your retirement? What can you do to either prevent them or at least be prepared to deal with them if they arise? Spend some time thinking about this now and you’ll greatly improve your odds for a successful retirement.
By the way, the Grand Canyon hike went off without a hitch. Time to rest my feet for a while and start planning the next adventure.