We at Cornerstone have discussed low interest rates from a macro viewpoint periodically, but today we want to touch on the real-life applications of what that means for retirees seeking income from their investments. Simply put, retirees don’t like spending down their savings. However, in today’s low-rate environment, which likely won’t change for years, it’s more expensive than ever to “buy” income from an investment portfolio.
Thus, low interest rates create a significant dilemma for income investors. A tried-and-true retirement income method – generating enough interest from investments to cover living expenses – just doesn’t exist right now for a lot of people.
To exemplify this, the average cost to generate $1,000 in income from a 50/50 balanced portfolio of diversified stocks and bonds historically has been about $25,000. Today, $1,000 of income costs approximately $80,000 from that same balanced portfolio.
In response, many investors are tempted to reach for yield either by purchasing lower quality bonds or equities with higher dividend yields. But it is important to weigh the risk/reward considerations of such moves. In some instances, the income investor’s expectations and behaviors need to be adjusted accordingly.
As the chart below references, over time the average bond yield is approximately 4.5 percent and the average equity dividend yield is about 4.1 percent. For 2020, these numbers stood at 0.9 percent and 1.6 percent, respectively.
What's most troublesome for income investors is these yield drops in bonds and equity dividends are taking place at the same time. Historically, periods of low dividend yields or low interest rates have cancelled themselves out to some extent. But today both are well below long-term averages.
From an equity perspective, the biggest reason for this is that companies are increasingly using stock repurchases to return money to shareholders. This has decreased dividend yields and shot equity valuations to historical highs. As for bond yields, they plummeted due to several factors. Most importantly, it was because of an artificially depressed interest rate environment resulting from the Federal Reserve’s involvement in bond purchases.
To further exemplify the high cost of income, the average historical cost to generate $1,000 of income from a 50/50 balanced portfolio of diversified stocks and bonds is $26,267. That means an investor could expect an instant yield of approximately 4 percent from financial assets. This is what spawned the popular (but outdated) 4-percent safe withdrawal rate.
However, as the chart below shows, the cost of $1,000 in interest income is now about $79,118:
We encounter this investor dilemma in many of our conversations. Overall, retirees are a behavioral bunch (aren’t we all, really?). The same statistics that produced the above chart illustrate how retirees plan to behave with their money (notice a substantial amount have no plan):
In today’s interest rate environment, the last two approaches aren’t as realistic as they have been in the past. This is why we believe in the increased importance of a customized strategy that creatively balances risk versus reward until interest rates get to a more normalized value.
Most importantly for income investors, this doesn’t mean merely reaching for yield in fixed income or equities by moving down the quality spectrum. Additionally, taking a rational viewpoint, it also increases the importance of the focus we take on maximizing the after-tax return from a portfolio by using creative distribution strategies between the different buckets of money that are taxed differently. All in all, investors should know it is possible to generate income from investments without being overly risky.
When is the Big Dip Coming?
We've been closely tracking the overbought nature of the trusty Map Signals’ Big Money Index (BMI) for some time. For investors right now, it’s like being on a rollercoaster, slowly clicking up the giant first hill, wondering when the apex and subsequent drop are coming. Click, click, click…
To start the year, we talked about some predictions, like the S&P 500 peaking around January 18, 2021 (give or take a few days) before a healthy, necessary correction. As of this writing, the S&P 500 seems to have peaked on January 21, 2021, at 3,853.07.
But remember, to see market prices fall we still need to see the BMI fall first. The market went overbought on December 2, 2020, and the BMI has been flatlining since then:
Since the BMI seemingly doesn’t want to fall yet, the rollercoaster clicks on.
How do we figure the path forward? Again, historical data is a fantastic guide.
Looking back over the last five years, the average daily signal count per day within the BMI is 64 buys and 52 sells. For comparative purposes, in the 55 trading days leading up to the election (starting on August 17, 2020), the average daily signals were 57 buys and 39 sells. So, not too far from average. Since then, a market rise started on November 3, 2020, and the average daily signals have diverted greatly:
More fascinating, the 147 average buy signals for the post-election period are an all-time high for the last 30 years. Looking back 15 years since exchange traded funds pushed market volumes higher, you can see the drops are never too far behind the high peaks:
To hammer home how hot the buying has been, remember that sector buying rarely shows yellow, which indicates 25 percent or more of a sector’s “universe” being bought in a given week. Since Election Day there have been multiple yellow boxes every single week. Even last week we saw seven of 11 sectors bought:
So, going back to the original question about when the big dip is coming, well we certainly don't want to get into specific predictions because we prefer to follow data. Yet, the story the data are telling indicates we're definitely getting there, and euphoria is in the air. History shows elation often precedes the next healthy market reset.
We think that whether this most recent peak is it will be borne out within the next week to 10 days. At that point we’ll reevaluate, because as anyone who’s been on a big rollercoaster knows, the climb up (i.e., an overbought market) can last a while.
Securities sold through CoreCap Investments, LLC. Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial Services, CoreCap Investments, and CoreCap Advisors are separate and unafﬁliated entities.