The Investment Scientist

In this article, I will not discuss the Credit Suisse collapse and rescue that just happened less than ten hours ago, since I don’t understand the Swiss banking system as well as I understand the US system. Here in the United States, we have had a rapid succession of specialty bank collapses: Silvergate Bank, Silicon Valley Bank (SVB) and Signature Bank. Most of their depositors are super wealthy people or businesses whose deposits amount to much more than the 250k guaranteed by the FDIC. The majority of American banks do not have that kind of customer profile and the majority of American depositors have less than $250k in their bank accounts. Does that make the rest of the banks in America safe? I am afraid not. 

Though the depositor profiles may be different, all banks invest in the same “safe” government or government-backed debt securities, and all banks have unrecognized losses in those securities. By some estimates, the entire US banking system has $660B in unrecognized losses. 

There is so much to write about the Silicon Valley Bank (SVB) collapse and the subsequent government rescue plan. Let me start by saying that I do agree that the government’s action has arrested a panic that could lead to a domino of bank collapses. In today’s article, I’d like to present my thought that the rescue mechanism as it is now could lead to more problems down the road that one day might become an even bigger crisis. 

During 2020 and 2021, the Fed printed $5T to combat a potential economic collapse caused by Covid 19. Some of this newly minted money found its way into Silicon Valley Bank (SVB) deposits. Since the short-term interest rate at that time was essentially at zero, SVB invested a large portion of the money into long-maturity mortgage-backed securities (MBS) that at the time were at least yielding somewhere around 1.6%.

If we look at the SVB Balance Sheet, this investment is classified as Held-to-maturity securities on the asset side (shown in green.) This means if they hold the securities until maturity, they will definitely not lose money. But if they are forced to sell before maturity in a rising rate environment, they will lose money. 

Two months ago I wrote about the top ten reasons that Equity Index Annuities are ripoffs, but apparently I did not exhaust all possible ways an insurance company can get at your money. Recently, a client of mine asked me to review an EIA he bought two years ago. Oh my goodness! I have had my eyes opened and my heart disgusted once again!

The contract I looked at for my client put his money in a so-called “1 Year Average Participation Index Account” with an initial participation rate of 30% and a minimum participation rate of 10%.

Injury #1: With all EIAs, you give up the dividend, which is about 2% a year. So you need to plan to give up 20% in ten years and 40% in 20 years.

Injury #2: This injury stems from the word “average.” Let’s say in a given year, the market goes up 10%, you are not getting this 10% growth, you are getting the “average” growth. You have to read the whole contract to understand what a ripoff this term is. Let’s assume that in January, the market goes down 1%, and in subsequent months, the market goes up 1%. So adding all the gains together, for the whole year the market goes up 10%. The way they do the average is this: for every month, they will calculate the Year to Month Return, and then average them. The effect of this is to cut the annual return number by half. In a year the annual return of the market is 10%, after the insurance company applies their “average”, the return becomes 5%. See the table below for an illustration.

“The January Effect” refers to two phenomena in the stock market that elude good explanation: 

1. The market tends to perform exceptionally well in January.
2. The market’s January return tends to predict the rest of the year. That is, if we have a good return in January, it is more than likely that we will have a good return for the whole year.

In recent years, however, people have been saying that the January Effect is weakening. So today I am going to revisit these two phenomena using the S&P 500 return data from the last 10 years. In the table below, I calculated the January returns (and the annual returns) from 2013 to 2022 and arranged them from the lowest to the highest. 

I am talking about an HSA – the Health Saving Account. Why is it the best? Because it is the only saving vehicle that gives you triple tax benefits. The money goes into the account pre-tax, the money inside can grow tax-free, and all health-related qualified withdrawals are tax-exempt. 

However, not everybody is qualified to open such an account. Only folks who have an HDHP – High Deductible Health Plan can contribute to such an account, and the contribution limits are relatively low. For 2022, the limits are $3650 for an individual or $7300 for a family; for 2023, the limits are $3850 and $7750 respectively. 

Who should have an HDHP in order to have an HSA? Folks who are young or very healthy. In my case, I am not that young, but I am super healthy and I plan to live a long life, so an HDHP makes sense for me. Not only can I pay a lower health insurance premium, but I can also open an HSA and begin to save for my future healthcare needs. 

I have a 14-year-old son who has done some odd jobs for my business this year. What he did not know until now is that I actually paid him about $7000 in 2022 and put $6000 of that into a kiddy Roth IRA that I opened for him. 

This is how I told him.  I pulled him aside and announced: “Son, I just made you a millionaire!” That got his attention away from playing video games!  He asked: “How so?”

“Daddy just put $6000 into your Roth IRA. In a few days, when it’s 2023, daddy will put another $6500 into your Roth IRA. This type of account lets your money grow tax-free, and when you retire, lets you withdraw the money tax-free. Let’s say you have a very productive life and retire at 74. If you don’t touch the money until then, how much money will you have assuming the money grows at 8%?”

Being the smart boy that he is, my son quickly figured out he should use the compounding formula: 8% per year, compounding over (74-14) = 60 years will make the money 1.08^60 = 101 times over. Since he gets $6000+$6500 = $13,500 from daddy (actually by his own work.) $13,500*101 = $1,363,500! He broke out in a smile! 

I smiled as well since I taught him a lesson about investing: start early, stay disciplined and let compounding work its magic. 

A client of mine came to me very worried because at this time last year, his account was $1.35mm and now it’s only $1.19mm. That’s a “loss” of nearly 12% in one year. “At this rate, am I gonna lose everything in 8 years?” he asked. 

I showed him a number buried deep in his statement, and he immediately regained confidence that he is not losing, he is, in fact, gaining. What number did I show him? Just stop reading for a minute to think about that. After one minute you can read on.

….

Here are your answers to the survey question: “What You Learn The Most From Warren Buffett and Charlie Munger?” Most people pick “They are patient” as their top take-away, followed by “They are value-oriented”.

If I had been asked the same question ten years ago, I would have picked these two as well. However, today I want to discuss the point that came in third, that they stay alive and sharp. 

Thank you for all the responses to my last survey.  Here is the breakdown of your answers – the table below shows the percentage of you who think the specific asset is an enduring asset.

Bitcoin is not an enduring asset. The so-called cryptocurrency is neither used for any meaningful exchange, the primary function of a currency, nor is it safe from hacking or outright bans from governments. 

My last newsletter illustrated an actual example of a client portfolio that had fallen 17% in value over the previous 12 months.  Despite that, the portfolio’s projected income had increased by 10%.

This client’s portfolio is a 50/50 portfolio, with 50% in bond funds and 50% in stock funds. The same factor that drives the portfolio value’s fall also drives the increase in income. The factor I’m talking about is the long-term interest rates. 

Don’t mistake this for the Fed’s interest rate hike. The Fed only controls the overnight Fed fund rate, it does not control the long rates like the 5-year rate, 10-year rate, etc. It is the market that sets the long rates. When the market believes that the Fed needs to tighten up a lot more to control inflation, long rates increase across the board, causing both stock and bond values to fall. (If the central bank will pay high overnight interest long into the future, all existing investments become less valuable.)

In a previous article, I argued that for folks in the wealth accumulation phase, market discounts like we are getting now, between 22% of the S&P 500 and 33% of the Nasdaq, are actually good news. The same amount of money can now buy more enduring assets. And yes, owning more enduring assets in retirement is absolutely better than owning fewer! In the future, I shall write another article about what constitutes enduring assets (#). But back to the current topic.

I got an email from a retired client of mine, who asked: “What about me? I am past the accumulation phase. I need to draw a fixed income from my portfolio, and I just saw it shrink by nearly 20%.” We did a review of his portfolio, afterward, he felt much more reassured.

Did I do some kind of magic trick? No, I simply showed him what was hidden in his portfolio statements. I compared not just the value of his portfolio, but also his projected yearly portfolio income between August of last year to this August. Here is the comparison table.