Greath Wealth -Investment Information & Services

Fraction of DFA Bond Funds in U.S. Government Debt

Although the possibility of a U.S. Government default on its debt may be a surprise to some, it’s something I’ve considered for years, as a Houston based financial advisor, and invested my clients money accordingly.  Sure, the government may raise the debt ceiling, but if they keep doing this sooner or later, and probably sooner rather than later, they’re going to overload the system and default on the debt, no matter how high they raise the ceiling.

Why can’t they just keep printing money?  Because money is a representation of labor, and simply printing more money doesn’t increase the supply of stored labor.  Hence, doubling the supply of money in circulation will, sooner or later, reduce the amount of labor a dollar will purchase by 50%.  It’s really as simple as that.  Forget all the smoke and mirrors and pundits.  They get paid big bucks for the interviews, while you’re left with a dollar that’s worth half of what it use to be.

So what have I been doing over the years with this knowledge?  Avoiding U.S. Government bonds as much as reasonably possible.  Again, one could see and hear the train coming from way, way off.

So where, specifically, have I been investing my clients’ taxable bond money?  Unless its in a taxable portfolio, I’ve been investing in DFA’s Two Year and Five Year Global Bond Funds.  As the name implies, they’re global.  Moreover, although they’re global, their debt is very high quality.

What percentage of these funds are in U.S. Government debt?  On the two year fund, 35 percent of the funds are in domestic bonds and ~74 percent of that number is in U.S. Government bonds.  Hence, if you have $100,000 invested in this fund, only $26,000 (.35 x .74 x $100,000 = $26,000) of it is in U.S. Government debt.

Similarly, on the five year global bond fund only 22 percent of it is in domestic debt and of this, 60 percent of it is in U.S. Government debt.  Therefore, if you have $100,000 invested in this fund only $13,000 of it is in U.S. Government debt.

So what happens if the U.S. Government defaults?  It’s unlikely it will default on the entire amount, and maybe just on the interest.  Sure, any default will hurt the investor, but the exposure to U.S. Government debt in these funds is minimal.

Where is the rest of the DFA global bond fund money invested?  As mentioned above, the debt is held by high quality borrowers.  Who are these borrowers?  They vary day by day, but typical borrowers may include diversified government entities like the Swiss and Hong Kong governments (both in the top ten globally – no, the U.S. isn’t even in the top ten), and high quality corporate borrowers like Toyota (now just AA due to “weak profitability”) and Exxon Mobil

This brings up an interesting point:  What happens to a U.S. politician if the U.S. Government defaults?  Probably nothing, as they’ll just blame it on the other party and get reelected.

Conversely, what happens if a corporation unexpectedly defaults on its bonds?  Someone will likely lose his job.  And who’s in a better position to prevent a looming default, a government official or a corporate boss?  Although I have my doubts about corporate cronies, I’d bet on them any day before I’d bet on the government.

So what’s the bottom line?  Do I think the U.S. Government will default on its debt?  No, but it is certainly possible and something I’ve been looking at for years.  Yes, it will impact many things, but that’s many additional discussions.  The thing to keep in mind is that the DFA Two Year and Five Year Global Bond Funds, while not immune to a U.S. Government default, are at least well insulated.

Thanks,

Rod

Brief Thoughts on the Past Quarter

In short:  Schulz Financial portfolios ended the quarter within +/- 1% of where they started the quarter, in spite of a series of bad economic information from late May through June, and even carrying into July.  If portfolios can remain strong during the hard times they’re that much more poised for strong growth when things rebound.

More specifically, the DJIA started and ended the quarter at ~12,250, with a high of ~12,800 and a low of ~11,800.  That may sound like a big swing, but if you take the mid-point of 12,300 and consider the market took swings of +/- 4%, that’s not out of line of what to expect.

How do I get this?  I start with a market annual standard deviation of 17%, convert it to a quarterly standard deviation of approximately 8% and then draw my conclusion.  Bottom line:  last quarter’s swing was nothing out of the statistical ordinary.

What about the federal debt ceiling situation, etc.?  That’s a topic for another discussion.  But the thing to reflect on now is that last quarter was basically a break-even period in spite of some significantly bad economic news.

What should one do at this point?  Keep forging ahead…

Samsonite Goes to Hong Kong

To be sure, Samsonite has been going to Hong Kong for generations.  However, this time it’s a bit different as they’re going to Hong Kong to raise capital on the Hong Kong Stock Exchange.  Why not simply go to NASDAQ or the NYSE?  I don’t know, but I’m sure they have their reasons.

One of the reasons may be that Asia is the home of their fastest growing markets.  Other reasons for the change may be the tax angles, the regulatory situation and/or currency exchange rates.  But for whatever reason or combination of reasons, Samsonite is going to Hong Kong to raise capital.

The take away for me and my clients is that the economy is getting more global in every aspect, every day.  Companies are no longer going overseas just to find cheap manufacturing labor or to peddle their goods, but rather to raise capital.

What’s the next logical step?  My guess is that some of the companies may be transferring their headquarters overseas just as Halliburton transferred its headquarters to Dubai a few years ago.  And they’ll be making the overseas moves for a number of reasons.

No, I’m not trying to make a political statement or forecast gloom and doom for the United States.  However, one thing I am in the midst of doing is recommending to my clients that they put an increasing percentage of their portfolios in overseas markets.  How much?  It depends on the client, the portfolio and other factors, some of which will be discussed in future blogs.

Thanks,

Rod

Imagine Some Positive Economic News

Take a moment to think about the economic news you’ve been hearing over the past 2.5 years. Have you heard anything that’s consistently positive?

To be sure, it’s been ugly since the spring of 2008, really ugly. Nevertheless, the Dow Jones Industrial Average (DJIA) has hung in at around 10,000. Sure, it dipped to ~6600 in March of 2009, and it has recently rallied to 10,900.  But overall, it has generally hung in at approximately 10,000 for the last year.

With this in mind, can you imagine what the DJIA might do if we had some consistently positive economic news, for any reason?

I’m not clairvoyant, but capitalism is globally spreading and I don’t think we’re about to reenter the Dark Ages.  Hence, it’s reasonable to think that at some point things will turn positive.  Even if this doesn’t happen in the United States, it will happen somewhere and all the portfolios I manage have a global component.

Even here in the U.S., there is some interesting data, which includes:

* Americas’s large corporations are sitting on more cash than at any time in the last 60 years, even when adjusted for inflation.  Can you imagine what will likely happen when this cash comes off the sidelines and enters the investment arena, either domestically or internationally?

* Prior to the recent market rally, the price to earnings ratio (P/E) of the S&P 500 was approximately 12, even with interest rates being the lowest they’ve been in decades.  In comparison, the historical P/E ratio of the S&P 500 is approximately 14 – 15.  Moreover, it’s generally been in the high teens to mid 20s since the mid to late 1980s.  It’s just a simple calculation to see where the market would be if it returns to historical standards with an adjustment for current interest rates.

* Corporations are adjusting for the current economic environment, as evidenced by the following comment on the front page of Monday’s Wall Street Journal:  “U.S. companies are rebounding quickly from the recession and posting near-historic profits…” Businesses, as a function of the human behavior that controls them, will always organically adjust for survival and growth in the environment they face.

No, I’m not clairvoyant and I’m not making a blatant prediction about the market in the short or mid-term.  However, I do think it’s interesting that the DJIA has hung around 10,000 for the past year with overwhelmingly negative economic news surrounding the situation.  Hence, it’s only common sense to believe that the market will turn north at some point with positive economic news.

Thank you for taking a minute to consider my thoughts.  As always, drop me a note or give me a call if you have any questions or comments, or if I can be of any assistance.

Rod

What Happens if the U.S. Government Goes Broke?

What happens to investors if the U.S. government goes broke? With the condition of Greece, Spain, Portugal, Italy, Great Britain and yes, the U.S., this is a question any prudent investor must ask. No, I don’t have a crystal ball, but we can look at the broad picture and analyze the situation.

Unfortunately, if you’re crazy enough to loan the U.S. government money; i.e., to purchase U.S. government bonds at this point, you’re out of luck. If the government goes broke, they’ll default on their bonds and you’ll be paid less than a dollar on the dollar.

What’s perhaps more likely is that the U.S. government will inflate its way out of debt by simply printing more money and thus devaluing everyone’s cash. This will, in all likelihood, create rampant inflation, thus devaluing all bonds and creating the same effect as the U.S. government defaulting on their debt. The only difference is that they take all bonds down with them in this case.

But what about stock investors? Fortunately, even if the U.S. government goes broke, I believe people will continue to drink Coke, go to McDonald’s, purchase gas, buy Proctor & Gamble toothpaste, wear out their tires and do most of the “normal” things they do in their daily lives. Hence, corporations will continue to retain monetary value.

Yes, I believe that inflation will hurt the stock market and yes, I believe there will be riots in the streets if the U.S. government goes broke. However, I also believe that people around the world (remember that most of our companies are global) will continue to go about their daily lives as best they can.

Ultimately, the U.S. will go the way of the Roman Empire. We don’t know when or how fast, but one constant in world history is that nations rise and fall. But I believe that mankind, and thus the global economy, will continue to march forward. We don’t sail around the world in wood ships anymore. And likewise, with or without the U.S. government, I believe the global economy will continue to march forward.

What do you think?

Thanks,

Rod

An Interesting Fact

By any conventional measure, bonds are a lower risk investment than equities (stocks), particularly government bonds.  However, although I continue to design portfolios using bonds as an instrument to dampen volatility, I continue to wonder, “are government bonds really safer than stocks”?

You may remember a post a while back about a recommendation to a client to make an investment in the S&P 100 not long after the market bottomed out and began to rise.  Although the move was particularly well timed and the money had come from bonds that had been called, I’m not about to say I saw the rapid rise in stocks coming.  Yes, it has been a rapid rise, as I just read, a day or two ago, that the last six months have represented one of the six strongest six month periods for stocks in the history of the market.

What was I thinking when I made the S&P 100 recommendation?  First and foremost was the discipline of sticking to rebalancing a portfolio.  One needs to pay attention to the basics.  It doesn’t mean you have to follow them 100 percent, but like blocking and tackling, you have to pay attention to the basics.

The second thing that was running through my mind was the rising risk of loaning money to the U.S. government, which, traditionally, is a big part of nearly any bond portfolio.

Yes, everyone in the world who can understand a standard news source knows about the rising U.S. government debt.  But today, in a Washington Times article by Richard Rahn, a senior fellow at the Cato Institute and the Chairman of the Institute for Global Economic Growth, I read the following super-interesting fact:

“The U.S. entitlement programs (Social Security, Medicare, Medicaid, etc.)…will take more than 100 percent of all federal tax revenue this year, requiring that virtually all of the other government programs, including defense and interest payments on the debt, be funded by more borrowing.”

That’s staggering, truly staggering.  Would you consider a loan to such an entity to be a low-risk investment?

I can explain and lecture on bell curves and standard deviations all day long, but everyone, including myself, has to be concerned about loaning money to such an entity, no matter what the historical profile looks like.

What to do? I’m glad, really, really glad, that none of my clients have an excessively large exposure to U.S. government bonds.  Yes, many, especially my older clients, have a significant bond position, but they’re all in highly diversified bond positions.

Also, ironically, stocks may be lower risk than loans to the U.S. government.  Will they be completely immune from U.S. government and currency issues?  No.  But even if the U.S. government can’t meet debt payments or inflates its way down the road by simply printing more dollars, millions of people around the world will continue to drink Coke, fill their cars with ExxonMobil gasoline and use a computer powered by Windows (although I’m an Apple guy).  Capitalism will march onward.

What about gold?  It’s still just an inanimate commodity.

What else to do? If you’re depending much on an entitlement program, you may wish to give your dependency some serious thought.  Do I really think the U.S. would eliminate or seriously scale back its entitlement programs?  In all honesty, none of our politicians on either side of the isle have the political backbone to take on the issue.  However, time and again over the centuries, markets and balance sheets have proven to be stronger than political will or desire.  Ironically, the 60s generation that wanted peace and sex with everyone may run begging to the churches they have despised all their lives for handouts of basic life sustaining elements like bread and water.

Do I think the day of reckoning will happen within the next one to three years, as Mr. Rahn does?  You probably know by now that I’m not about to make a specific time dependent prediction like Mr. Rahn.

However, I do think it’s safe to say that it’s highly risky to loan money to an entity going the direction of the U.S. government or to depend on such an entity for an “entitled” payment.  Thus, informed investors may want to consider making their decisions accordingly.

Have a super day.

Thanks,

Rod