Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog. If you are interested in receiving this letter monthly by email, sign up here.
With a quarter of the year now gone, the stock market is essentially still flat for 2015. Throughout the year, stocks have seesawed back and forth trying to find their bearings. Although a few months of sideways movement is common behavior for markets, history teaches us that prices don’t typically remain in a sideways range for much longer than that. After a few months of consolidation, prices will usually break out in one direction or the other. The question of course is which way will they break?
Fundamentals continue to suggest to me that the break should be lower, not higher. Valuations are still extremely high, earnings are likely to fall this year, and monetary policy is getting incrementally tighter. Still, as I talked about last month, there would certainly be precedent for higher prices, it would just mean that markets have reached into undeniable bubble territory.
While markets will resolve these issues over the next several months, I think the most important change that I noticed in the first quarter of 2015 isn’t something that markets are focused on at all, but has the potential to have a massive influence for many years to come. In 2015, it seems that the Baby Boomer retirement wave is finally hitting.
In my own wealth management practice, I am seeing signs that retirement is starting to “cross the chasm” to mass market adoption. Within the last quarter, several of my clients have let me know that they are retiring this year. These are quintessential Baby Boomers, born between 1945 and 1955. They have been working for 40 years plus and are simply ready to move on to other things. I couldn’t be happier for these individuals. Each one of them deserves the opportunity to kick back and relax after decades of contribution to our economy.
Yet, as an asset manager, the decision to retire is bitter-sweet for me, because I know that clients who are retiring go from being asset accumulators to asset distributors. Put simply, rather than growing the balance of their accounts, these clients will now likely be drawing them down, or at best holding them flat. These clients will now be unlocking their savings for the reason that it was accumulated in the first place: to finance their retirement.
This trend, which I am observing on a micro level in my business, is likely to have a profound effect on capital markets. These clients and millions of Baby Boomers like them are the owners of America’s productive assets. The owners of those assets are undergoing a major shift in investment objective. They are going from a growth mentality to an income mentality.
For the last several decades, Corporate America has been managing American companies to a mandate which is now changing. Companies have been asked to produce growth at any cost, because higher stock prices indicated to Boomers that their retirement portfolios were growing, which made for happy shareholders.
Early on, companies generated growth by retaining earnings and reinvesting capital, and as organic growth has slowed, lately they have engineered growth by buying back shares. Even though many times these decisions were made at sub-optimal levels, owners typically didn’t mind because they were looking for capital appreciation. But now owners will ask to realize returns, and owners can only do that in two ways: either by receiving dividends or selling shares.
In an ideal environment, Boomers would be able to generate returns without having to sell assets. Income received from dividends and bond coupons would be enough. However, this isn’t a normal environment. Today very few if any assets are producing enough income to cover necessary expenses. With the dividend yield of the S&P 500 ETF at just 1.9% and the 10 year treasury yield at a similar level, back of the envelope math suggests that a Boomer would need a portfolio of $2.6 million to generate $50,000 per year in current income before taxes.
It’s my sense that most boomers and their financial advisors have probably not underwritten their retirement with the assumption of a 1.9% return on their investment portfolios though. This means that in order to generate the requisite income, Boomers will have to become sellers of assets in order to produce yield.
The question is: at what price will they be able to make these sales? Current owners, who are aging, will be selling to a younger generation. This actually represents a natural transfer of assets from one generation to the next. However, for most of the younger generation, incomes cannot support purchasing those assets at current price levels.
Real estate is perhaps the most tangible example of this phenomenon. Talk to a group of Millennials about buying real estate in Los Angeles, and more often than not you’ll hear “I don’t know how I could ever afford to buy a house here.” Securities markets are just as expensive, but the problem is masked by the fact that the buyer is only purchasing shares not whole businesses. Incomes cannot justify today’s market prices, and the result is that younger generations are purchasing much smaller percentages of companies than they otherwise would be able to. The younger generation is trying to build its ownership of assets, but it can’t in the current environment.
As a result, when Baby Boomers become incremental sellers of their portfolios, they will have to do it at prices that younger generations can afford. In other words, this is one more reason why markets are probably headed lower.
So what does all this mean for our investment portfolios?
It’s important to remember that while forces like these are real, they evolve at such a glacial pace that it’s tough to apply them along any meaningful timeframe. To be clear, we’re not making any near term investment decisions based on the fact that Baby Boomers are retiring.
Still, this information does have an impact on our assumptions for trends in reasonable valuation. I would be much more prone to believe that the PE multiple of the S&P 500 could reach 30x again if Baby Boomers were at a different stage of their lives. However, since they are not, I do expect average multiples to decline, not rise, over the coming decades. In my opinion, that makes it even more important for us to continue to hold cash. Valuations will fluctuate widely around their long term averages and the averages are probably trending lower.
If you’re a Baby Boomer considering or approaching retirement, it’s important to keep in mind that today’s asset prices are inflated. The economic value of a portfolio at today’s levels can not necessarily be taken at face value. Stress your assumptions about the rate of return that your portfolio will generate. And if you have a strong stomach you may want to assume that the true value of your invested portfolio is about 30-35% lower than current levels. From those prices the standard 5-8% growth assumptions are more reasonable. The other alternative, which is the path that we are taking, is to utilize the tax advantages of retirement accounts to sell at these high levels.
One of my mentors in this business once told me that a great advantage in his life was being born in 1943. That made him an early Baby Boomer who was always just one step ahead of his peers. Anything he bought, he got there just before a wave of buying came along to force up the price.
Today we find ourselves in that situation reversed. As Baby Boomers age all the assets that they have accumulated throughout their lives are now being distributed. It will behoove Baby Boomers to be selling earlier than their peers so that they can realize peak prices and preserve capital to reinvest at more favorable ones.
Conversely, younger generations should continue to save, but remain patient holding cash. I promise that eventually we will get a chance to purchase the productive assets of society at prices which are reasonable relative to our incomes. The reins of the American productive machine are now being transferred from one generation to the next. The transition will not be totally seamless, but for those who plan ahead, it can be extremely profitable–for this generation and the next.
Scott Krisiloff, CFA