Getting Older <> A Crash in Asset Prices

Last week I wrote about trends in emerging markets.  This week I stumbled upon an article from The Economist that discusses the demographic challenges facing developed markets – an aging population.  This is problem facing many developed economies including the US, but Japan, Germany, and Italy in particular.

First it’s best to describe the basic assumption associated with age groups and asset purchasing.  In general, working aged people buy assets and retiring people sell assets.  The former pushes prices up and the latter pushes prices down.  The article has some research that substantiates this:

• A paper by Elod Takats for BIS looked at home prices in 22 advanced economies.  He found that a 1% increase in old-age dependency ration (old people/working age people) was associated with a .66% drop in real home prices.
• The San Francisco Fed found that there has been a high correlation between the ratio of Americans aged 40-49 and those aged 60-69 and the market’s P/E ratio.

To me this indicates there could be some serious problems facing asset markets in developed economies; however, I don’t think it spells certain doom:

• Markets have likely discounted this.
• Elderly people may wind up working longer.
• More liberal immigration laws can help lower the average age.
• Monetary and fiscal policies can help address the problem of an aging a population.

Ultimately I think an aging population will have an effect on asset markets; however, I don’t think it will be severe. 

Where is the US?  In the short-term we appear to be aging; however, by 2025 we should have a strong rebound in working-aged individuals.

Dividends are Good Depending on the Source

Dividend paying stocks are becoming very popular among investors.  The FT notes investors have been moving aggressively into dividend ETFs since July.

There are many reasons to like these kinds of stocks:

• They tend to be bigger companies that have strong balance sheets & diverse revenue streams
• Given the above, those companies should be less volatile than the overall market and provide some stability of the market moves down
• Relative to small cap equities and low yielding government bonds these companies are attractively valued
• From the middle to the end of a cyclical bull market cycle large caps typically perform the best  

The key when buying a dividend paying ETF or stock is that they meet the above criteria.  Just because a company pays a dividend doesn’t mean it’s financially strong.  The same goes when buying a dividend paying ETF; just because it has a high yield doesn’t mean you are getting quality.  Basically, looking only at the yield is a suckers bet.  If an ETF yields 6% but the value falls 20% than you still lose.

You need to know your Dividend ETFs.  What is the composition?  What are the screens?  How many stocks are in there?  What index do it track?  It is imperative you get those answers before you invest. 

Past Returns Can Get You Burned

Hedge fund manager John Paulson is no doubt a smart guy.  He made a lot of money shorting the subprime mortgage market in 2007 and 2008.  His large gains and the bet he made is even chronicled in the book The Greatest Trade Ever Made (and probably a few others).

Recently however, Paulson has not as much success.  His two largest hedge funds are down over 20% this year and he may soon have to start liquidating assets in order to meet the outflows.  If he starts selling the bulk of his investments it could cause the value of his remaining investments to fall, making matters worse.

Did Paulson make a great trade?  Absolutely.  It is also true that he has struggled as of late.  I cannot say for certain whether his initial trade was luck, or if Paulson is an unbelievably skilled trader who will eventually recover.   

The point is judging a manager based on one trade, good or bad, is probably not the best way to pick if you invest with him or her.  Investing money purely on past returns is a fool’s game.  You need to look at the process and whether or not it’s sustainable.  

Reinvest Dividends or Take the Cash?

There is a good, easy to understand article in the NYT about the advantages and disadvantages of reinvesting dividends you receive from stocks, ETFs, and mutual funds.  Here are some highlights, as well as some of my own additional comments:

Why You Should

• Automatic dollar cost averaging: by this I mean you are buying into the market over time and rather than all at once.  This helps limit volatility and theoretically attempts to purchase shares at the best average cost.
• No more tax calculation headaches: new tax rules require brokerage firms to track your tax basis.  Thus, they will automatically adjust (increase) your tax basis for dividends.
• Easily comparable rates of return: when you look at your return, you don’t have to add back dividends.  In fact, the Morningstar return assumes dividends are reinvested.
• Commission free purchases: if you pay commissions for purchases, this is a way to avoid them. 

Why You Shouldn't

• You need the income: you are foregoing the income generation that dividends brings.
• Taking earnings off the table: by taking the proceeds in cash, you can potentially reduce the volatility that the market can bring.
• Portfolio rebalancing: taking dividends in cash allows you to re-balance your portfolio with that cash.
• Possible concentration risk: by reinvesting the dividends you are increasing your exposure to that position.
• Phantom income: reinvesting the dividends generates tax, but not the cash to pay the tax.

As with everything else, the correct answer depends on the investor’s goals, objectives and possibly risk tolerance. 

A retiree who needs cash is probably better served by using the dividend income to support his or her lifestyle.  A younger investor who has a long time horizon may better be suited by reinvesting the dividends as he or she likely doesn’t need the cash and volatility is less of a concern given the time horizon.

Afraid Emerging Market Stocks are Too Risky for You? Here is a Solution...

Some investors shy away from emerging market stocks.  While I think it is prudent to invest in emerging markets in investor appropriate degrees, I can see why there is some aversion:

• Unfamiliarity
• More volatility
• Uncertain political & economic climate
• Currency risk
• Increased correlation (i.e. not a great diversifier anymore)

Despite the apprehension, there are positive facts about emerging markets that can’t be ignored:

• High debt levels in and other legacy economic issues in developed nations (see previous posts here, here, and here)
• Better demographics
• Increasing commodity prices, which puts pressure on  a developed nation’s consumption
• Decreased political risk relative to developed markets, an interesting switch from a decade or two ago (i.e. heightened political and social risk in developed nations).

Also, when I look at the Morningstar numbers the SPDR S&P 500 has a higher trailing P/E than the iShares MSCI Emerging Markets Index.  This means that despite having more reasons for higher growth in the future than the US equity market, emerging market equities are cheaper.  I must admit, however, I believe there are greater risks that such high growth is not met.

Still despite all the positive tailwinds associated with emerging markets, many investors still won’t pull the trigger.  There is an easy solution to this – buy domestic equities that have exposure to emerging markets.  This alleviates or lessens many of the concerns I highlighted earlier while still capturing the positives that emerging markets exposure brings.