Co-produced with Trapping Value

Almost as soon as people start their first job, they start thinking about retirement. The 9-5 grind starts the desire for a time when the routine no longer has to be followed. On the investing side, savings start flowing toward that goal. The intelligent investor knows that every penny saved is an extra penny earned and frugality becomes the best friend of the future retiree. As retirement approaches, and decades of planning start bearing fruit, everything starts falling into place for that final step to that plunge. But what if it’s all about to crumble? What if all the assumptions and formulas are about to fail? Is that likely or even possible today? We go over where the financial realities meet the retirement dreams and tell you why there are some serious risks to retiring today.

Risk 1: Exceptionally Low Interest Rates

The low interest rates have been a boon to the housing industry. They have helped mortgage refinancing and cash out refinancing, supporting the consumer. They have been a boon to the stock markets as companies have gotten ever lower costs year after year. They have helped buybacks as equity yields have exceeded debt yields. So why would exceptionally low interest rates be a risk?

They are a risk as a large part of your portfolio now yields next to nothing. If you want a risk-free buffer as investors have had in the past, well you will get paid precisely 0% (or close to that) for it. This is what Jim Grant famously coined as the “Return-Free-Risk,” making a mockery of the term Risk-Free-Return. By buying bonds today you have virtually zero returns with a devastating downside. For example, the iShares 20+ Year Treasury Bond ETF (TLT) has a 30 day SEC yield of 1.15%. It also comes with a bond duration of 19.07 years.

Source: iShares

What’s Bond Duration you might ask? Well most people are unaware of this and when we asked people we got some interesting responses including one where someone said it was the time between James Bond movie releases. The correct answer is that Bond Duration is an approximate measure of a bond’s price sensitivity to changes in interest rates. Duration in effect, measures the approximate amount of capital gain or losses a bond portfolio will incur with changing interest rates.

If a bond portfolio has a duration of 10 years, for example, its price will rise about 10% if its yield drops by a percentage point (100 basis points), and its price will fall by about 10% if its yield rises by 1%. Similarly, if a bond portfolio has a duration of five years, its price can be expected to rise/fall about 5% for a change of 100 basis points in its yield. Since interest rates can only go up from here, the probability of capital losses is what we need to focus on.

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Now let’s apply this to the TLT example from above.

We have a duration of 19 years – you are essentially going to lose 19% in capital if interest rates rise 100 basis points (1%) across the curve. Now remember that you are getting 1.15% in yield from TLT. So in essence you are losing 16.5 years (19%/1.15%) of interest payments in capital losses, if interest rates move 100 basis points.

Those are approximations and concepts like “convexity” will alter final performance. But the crux of the issue is correct. Exceptional risk for virtually no returns. Those retiring today are now all-in on this interest suppressions experiment and the risks for a bond blow-up are rather extreme.

Risk 2: Exceptionally Unpriced Inflation Risk

The other side of the low interest conundrum is that no one anywhere is pricing in inflation risk. Real interest rates, that’s actual (nominal) interest rates minus inflation, are firmly negative. That’s coupled with the largest expansion of monetary stimulus in the history of mankind. So far neither the bond market nor the Federal Reserve seem remotely concerned. Fiscal expansion continues unabated and debt is being piled on at the fastest pace. History has shown us that nominal GDP and inflation often swings with rapid money supply growth.

Source: isabelnet.com

If we get an huge inflation spike, it will likely be a very big whammy to both equity prices and to bond prices. Right now, neither market has priced it in, making it one of the real outlier years where the traditional 60/40 portfolio (or 60% equity and 40% bonds) could suffer a 25%-plus decline. We have addressed this risk and its timeline and you can read our thoughts on it here and here. We will be following this threat over time and recommending what is best likely to work as an offset.

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Risk 3: Exceptionally-Expensive Multiples For Broad Market

While the first two risks impact the bond market more, this one has a direct impact on equity return. There are many measures of valuation but we like Enterprise Value to EBITDA and its strong correlation with forward returns. This valuation metric also is unique because it takes into account debt levels which most other valuation methods don’t. Today it’s projecting a negative annualized return for the next decade.

Source: Neal Falkenberry, Twitter, June 30

Some better known slow-growing companies are trading at even higher multiples, upwards of 20X.

Price to sales is another measure we favor and that is not singing like a canary either. Current price to sales ratio is the highest ever and it has not even been adjusted for the extremely weak Q2-2020.

Source: isabelnet.com

Price to sales is a far better indicator than price to earnings, as sales are much harder to manipulate with accounting tricks. This ratio also adjusts for the fact that margins revert-to-mean over time and earnings are not always steady. All these measures suggest that the passive investing large-cap portfolio will produce under 3% a year over the next decade. Investors retiring and counting on 6%-9% equity returns will likely be extremely disappointed.

Risk 4: Walking toward an energy crisis

While the last thing that is on anyone’s mind is a shortage of oil or natural gas, the groundwork is being laid for a very tight energy market. The oil price war alongside the pandemic has cut budgets to the bare bone and energy capex has dried up. Rystad initially estimated a 17% decrease for 2020 capex:

Source: Rystad Energy

Recent surveys have shown that’s proving very conservative.

Source: World Oil

At this point the base decline rates in the system are beginning to come to the surface and we expect global production to decline in both 2020 and 2021.

As a retiree, there’s a built-in assumption that the economy will grow over time. If that assumption pans out and if the economic GDP output exceeds to 2019 levels at some point, perhaps in 2021 or even in 2022, the oil and gas supply will severely be lacking. Initially we could draw on inventories but that won’t last long. This could create a vicious spike which could again be very detrimental to non-energy equities. It also could limit GDP itself as the literal “fuel” for the GDP is missing. This also would reinforce all three risks mentioned above, notably risk 2, and create a feedback loop for inflation. While supply will respond to higher prices, it could make for some difficult years for the new retiree.

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Conclusion

We brought up four risks today that everyone retiring soon should consider. While risks exist all the time, the key difference today is that very few assets are priced for the risk of the current environment. We have not even discussed risks specific to COVID-19 as that’s a whole different can of worms. Investors should not assume that the traditional 60/40 portfolio (60% stocks, 40% bonds) will navigate this remotely well. In fact, it seems guaranteed to not deliver the required returns for retirement. In Part 2, we will look at a few more risks that investors should make sure they are aware of before jumping into retirement. Once you have factored these in, you can plan your approach.

Thanks for reading! If you liked this article, and want to be notified about the 2nd part of the series, please scroll up and click “Follow” next to my name to receive our future updates.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Treading Softly, Beyond Saving, Trapping Value, PendragonY, Preferred Stock Trader, and Long Player all are supporting contributors for High Dividend Opportunities.



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