No Alternative

Currently, the outlook for retirees looking for income is dim. Money market funds are paying close to 0% interest. Short-term treasury bills are yielding less than 0.3% for a one-year maturity. Tax-free municipal bonds have recovered from the credit crisis but the California, Indiana, Nevada, and New York (CINN) credit default swaps are climbing; California's debt has been downgraded. Real Estate foreclosures continue and banks are failing. The "safe havens" investors fled to in the 80s and 90s during market downturns don't look as appealing as they once did.

The bear market continues in money market funds. According to Bernanke's semiannual report to Congress on Wednesday, rates will continue to remain low.

"The target for the federal funds rate has been maintained at a historically low range of 0 to 1/4 percent since December 2008. The FOMC continues to anticipate that economic conditions--including low rates of resource utilization, subdued inflation trends, and stable inflation expectations--are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

It's hard to believe that money market funds used to pay 4% annually just three years ago. With rates as low as they are today, retirees are forced to seek higher returns with added risk. Here’s a chart of last year’s mutual fund flows data showing an incredible inflow into bonds:

Record bond inflows, while interest rates are at record lows, is cause for worry. In the 80s, investors could sidestep an economic downturn in equities while earning yields above 8% in 5-year Treasury Bonds. Since 1981, bonds have been in a secular bull market. It is our belief this secular bull market is coming to an end and rising interest rates to combat inflation will soon be on our doorstep. Here's how long it took for short-term interest rates to start rising in the last few market downturns:

*Yields fell again from October 2002 to June 2003 from 1.7% to 0.7%

If 0.3% doesn't meet your income needs, maybe the municipal bonds from state governments will? That is, if you can find a state that can balance its budget. We can look at credit ratings and credit default swaps to understand the level of risk that some municipal bonds entail. California was recently downgraded to A- by Standard & Poor's, still the lowest rating for state bond issuances in the nation. "According to the nonpartisan Center on Budget and Policy Priorities, 39 state governments are struggling with shortfalls this fiscal year."–California Debt Rating Cut as Cash Crunch Looms

Here is a chart of the CINN-state credit default swap (CDS) spreads. Higher spreads tell us that sellers of credit default swaps are charging more for their protection.

Here's a list of current CDS spreads to consider as of February 25th:

What about a bank CD? Here are some things to consider:

  • The FDIC's Deposit Insurance Fund balance is negative .85 billion dollars.
  • In 2008, there were
    • 252 institutions flagged as problem institutions
    • 25 institutions flagged as failed institutions
    • 5 institutions flagged as assisted institutions
  • In 2009, there were
    • 702 institutions flagged as problem institutions
    • 140 institutions flagged as failed institutions
    • 8 institutions flagged as assisted institutions

Like every investment out there, you want to look at the counter party risk of the institution you're with. For annuities, you want to look at the insurance company to make sure it is financially able to meet its obligations. Some annuities are currently promising 10% returns using sophisticated models with no risk—if it sounds too good to be true, it probably is. Collateralized debt obligations (CDOs) were thought to be too good to be true and look what happened to them. Just ask yourself, looking at the numbers above, where can one honestly invest to get 10% returns safely without annuitizing? The insurance companies are basing their ability to meet their obligations to pay out the difference between your investments and a 5 to 10% returns based on financial alchemy and leverage. I read this on the cover page of an annuity company:

Guarantees are subject to the claims paying ability of *the* Company. They don't apply to the investment performance or safety of the underlying investment options.
Not a deposit • Not FDIC or NCUSIF insured• Not guaranteed by the institution • Not insured by any federal government agency • May lose value

The stock market isn't safe either; however, quality companies with strong balance sheets exist. We especially find this in the energy sector. Andrew Gould, CEO of Schlumberger (SLB), recently said that discussions on price concessions are no longer an issue for the company. He said, "The real risk is that if oil prices accelerate then in the supply industry, certain shortages will appear quite quickly." Talking about supply… from September 2009, the natural gas surplus has shrunk from 374 Bcf (3,449-3,075) above the five-year average to no more than 13 Bcf, despite a 41% bounce in the rig count since September according to the Baker Hughes Rig Count historical report. Currently, Baker Hughes (BHI) has a trailing price-to-earnings ratio (P/E) of 9, National Oilwell Varco (NOV) has a trailing P/E of 9, and Smith International (SII) has a trailing P/E of 11 after its merger announcement with Schlumberger.

There are few "safe" locations to find income in the current environment due to the credit crisis. The Federal Reserve Bank is maintaining a low-interest-rate environment as adjustable rate mortgages convert to long-term fixed mortgages and banks return to profit. To a retiree, this is the perfect income storm. Mutual fund investors have flocked from money market to bonds at record low rates of interest. It is extremely difficult to say whether rates start rising or we go the way of Japan (low interest rates over a long period of time). Once inventory restocking has dissipated, the question of the consumer’s health will need to be answered. By mid-year, that outlook is not anticipated to be much better than it is now. Marc Faber’s anticipated 20% correction after the next new high looks right on the money.

Market Analytics

As I discussed with clients in our weekly commentary a week ago, I felt that the market rally that started on February 5th was overbought and likely to correct last week. It did, but not by very much considering all of the negative announcements (consumer confidence, new home sales, and jobless claims). This may be a confirming hint that the correction is over—when bad news does very little to move the market. A few technical markers I was watching have held this week and thanks to Newmont's (NEM) earnings on Thursday, precious metal stocks have put in a short-term bottom; potentially creating an intermediate-term bottom. I say potentially because we need three things to happen now:

  1. Close above to confirm a trend reversal (higher low and a higher high)
  2. Break above the declining trendline from the December high near
  3. Break above 60 on the RSI to confirm a bullish shift

Another indicator pointing towards a reversal in the intermediate trend for precious metals is the percentage of stocks above the 50-day average within the GDX. This indicator is rising from oversold levels, confirming the rally.

The jury is still out on whether the January stock market correction is over, but I'm greatly encouraged by the price action last week and by today’s higher close above the 50-day moving average. Thursday's 17-point market reversal in the S&P 500 created a second bullish hammer (the first I discussed with clients in our proprietary commentary on February 5th). A hammer is a candlestick pattern that stems from the Japanese translation of takuri. According to Steve Nison, takuri means “trying to gauge the depth of the water by feeling for its bottom”. It would be very difficult for the bulls to wrestle back such a drop from the bears on Thursday unless buying power was growing under this market and selling pressure was declining. In fact, declining issues have dropped significantly from the Tuesday sell-off on lower consumer confidence. Additionally, Lowry's NYSE selling pressure registered a new 52-week low on February 26th. We shouldn’t see new lows in selling pressure if January represented a major market top and the next leg down in the secular bear market.

As a side note: are you watching the cyclical sectors?

I’m greatly encouraged by the performance of the cyclical sectors over the past few weeks. From a sector rotation stand point, cyclical stocks perform the best mid-cycle. Reference my brother’s article, Sector Rotation, for a lesson in the theory. Here is the performance of the S&P 500 sectors relative to the S&P 500 since the February 5th bottom. The chart shows that industrials, consumer discretionary, financials, and materials have been the best performers relative to the S&P 500.

About the Author

Wealth Advisor
ryan [dot] puplava [at] financialsense [dot] com ()