Could the markets really get worse?
For retired investors, it’s important to analyze not only where the markets have been over the last year but where they could go. The probability of depression-like declines in the markets is small, but the consequences could be severe if you don’t have a plan in place for retired clients.
THINKING THE UNTHINKABLE
If we have a continued decline in earnings and multiples, it’s conceivable we could see the S&P 500 Stock index at 500 (or the Dow Jones Industrial Average at 5,000). S&P 500 earnings are estimated to be about $80 a share for 2009, and declining rapidly. With a larger contraction in the economy, profits could decline to $50 a share. At a multiple of 10, that puts us at 500. Or, at profits of $65 and a multiple of eight, we are at 520.
I hope we don’t go there, but it’s not hard to see how we could get there with both profits and multiples under such downward pressure.
As John Maynard Keynes once said, “the markets can remain irrational longer than you can remain solvent. We don’t need to experience bread lines or dust bowls to get depression-like percentage declines in the markets. We simply need a further decline in profits, investor enthusiasm or some combination of both. Many companies could continue to operate as going concerns, but market valuations could reach levels we did not think were possible.
So what do you do? While every client’s situation is unique and advice must be tailored to the client’s risk profile, here is a four-step strategy that you may find helpful: (1) create a multi-year source of distributions; (2) protect principal with U.S. government securities; 3) capture yield with high-quality corporate bonds; and (4) take your long-term risks with diversified stocks.
Distributions. Make sure you have at least three years’ worth of distributions in cash or liquid securities, which for many clients would constitute about 12% to 15% of their portfolio. This allows clients to see that there is a stable source of funds for living expenses as the economy works through this cycle.
Government securities. Even with the ridiculously low yields available in Treasury and agency debt, you may need to hold a higher percentage through this cycle. This is a risk management decision, not a total return trade. Hold the bonds until they mature and collect the small amount of interest they pay. If markets continue to unwind, this backstop may prove critical in stabilizing the portfolio. U.S. debt may not be a good bet for a 45 year old, but for a 65 year old it is a prudent choice. Consider 25% to 30% in intermediate-term government bonds.
Corporate bonds. Once you have a multi-year source of distributions and a solid foundation of government bonds, you can reach for some additional cash flow by adding high-quality corporate bonds. Staying short- to intermediate-term is a prudent strategy, and make sure you diversify. Every company is vulnerable in this current climate. Consider 20% to 25% in diversified, high-quality corporate debt, and use the interest payments to fund distributions.
Diversified equities. At some point, the stock portion of the portfolio should provide gains to help enhance the retiree’s lifestyle. As a result, most retired investors need to hold stocks. But the real question is how much. Consider 20% to 30% in diversified equities, until we have more clarity about the future. If the market drops from here, the damage is limited to a small part of the portfolio. In the meantime, use the dividends to fund distributions.
There is no optimal allocation and you aren’t expected to predict the future. The best you can do is position portfolios for a range of possible outcomes given the current markets. Then weight the portfolios based on the consequences of those outcomes. For retirees, the greater risk is a severe hit to their capital that drags on for several years, as opposed to missing out on some of the returns from the next bull market. Thus, the greater weight in this market should be on principal protection and cash for distributions.
While it may be hard to reallocate after last year’s declines, it may be the right thing to do from a risk management standpoint. Don’t mistake the opportunities that these markets might present for younger investors with the unique risks faced by those who are trying to live off their money.
As tough as it might be to discuss these scenarios with retired clients, it is important to talk about the small but real possibility that things could get worse. Then let clients know that you believe markets will ultimately recover, but you want them to be positioned to get through the storm. Clients will likely appreciate your honest assessment of the situation and serious concern for their financial security.
