vaughnwoods

The stock market is off to a great start this year. Nevertheless, inflation concerns are rising along with reverse fears that higher gasoline prices will slow the recovery. In this newsletter I will focus on your long-term retirement planning strategies from the perspective of (1) the loss of purchasing power and what you can do about it, and (2) why it’s important to focus on sustainable distributions and (3) the forthcoming minor market correction as a necessary evil.

According to Credit Suisse research, the consumer price index (CPI) rose 2.9% in the last 12 months ending January 2012. This matched the average inflation rate over the last 90 years and households’ long-term inflation expectations in February.

At 2.9% inflation, a dollar would lose 68% of its purchasing power over 40 years. This means that every dollar a worker saves at age 25, would be worth 32¢ when they retire at age 65. What’s more, by age 85, that same dollar would only be worth 18¢.

Of course, we all know that inflation, as measured by the CPI, never tells the whole story. You see, the CPI is broken down into eight major categories: (1) food and beverages, (2) housing, (3) apparel, (4) transportation, (5) medical care, (6) recreation, (7) education and communication and (8) other goods and services (BLS.gov). Every year, prices in some of these categories will rise faster than the annual inflation rate, and some will rise slower. That is why our own personal experiences with rising prices don’t always match up with official government inflation rates. What’s more, your personal spending style can dramatically affect your personal inflation rate.

Here is a story to illustrate this point. Last Saturday, I was drifting through the mall with my wife. I spotted a blue and white men’s cotton long-sleeve shirt at Nordstrom’s. I asked my wife to guess the price tag, a game we enjoy playing. She named an outlandish figure: $275. She was off by about $150. No, the price wasn’t $125, she was off in the other direction. The price was $425. (To my concerned readers, there is no way I am going to spend anything close to $425 on a shirt!) So while it is widely acknowledged that apparel prices rose slower than 2.9% over the last 12 months, your personal inflation rate can change drastically just by where you shop and what you buy.

Let’s look at my Nordstrom’s experience from a different angle. If someone were to purchase 10 of these Nordstrom’s shirts in one year, they would spend $4,536.87 inclusive of state sales tax (a tax by the way that our Governor seeks to raise soon). Let’s assume that you want to pay for these shirts with interest earned on 12-month Treasuries. How much would you have to invest so that your interest payments cover your Nordstrom’s credit card bill? First we need the yield on 12-month Treasuries, which as of January, was 0.169% (MoneyCafe.com). With this information, we can calculate that our well-dressed investor must invest $2,684,538.46 in 12-month treasuries if he wants his interest payments to cover the cost of his shirts.

The above example is meant to illustrate that fixed-income savers can end up paying a heavy price for trying to fight the Fed. The Fed is keeping rates at record lows to spur investments into asset classes that offer greater appreciation potential, like stocks-which quickly expand consumer confidence when the market rises. However, investors still flock to investments like CDs and Treasuries because they think they are “risk-free”. Unfortunately, failing to understand the inherent risks of “risk-free” investments can devastate a retirement portfolio over time.

What are these risks? For one, inflation can leave you with a negative real return that cuts the value of your investments by 50% or more over time. Secondarily, “risk-free” investments can also subject savers to significant liquidity risks. Trying to withdraw money from a “safe” annuity or CD can cost you 10% or more of your initial investment in penalties. Finally, opportunity risks can be severe. During bull-market cycles, investors stuck in low-yielding “risk-free” investments can lose out on tens or hundreds of thousands of dollars from missed opportunity.

As you know, our value added proposition is to manage your portfolio mix according to where we estimate we are in the economic cycle. At certain times, fixed-rate investments will add a cushion against downside volatility while keeping a store of liquidity available for entering the markets at opportune markets. On other occasions, such as our current bull market, we reduce our fixed-rate holdings in favor of growth and income equities, which tend to increase their dividends each year over time. Large publicly traded companies that do increase their dividends annually tend to experience expanded equity valuations. So the net benefit to an investor can be a total return benefit, that is, a gradual increase in dividends (to keep pace with inflation) and capital appreciation.

However, even with returns better than the low fixed rates of certificates of deposit and short- term treasuries, it is time to acknowledge that it is more important than ever for investors to manage their distributions relative to their account size. When distributions outstrip income over extended periods only a reduction in distributions or an increase in additional capital can allow growth to catch the account up so as to make it a sustainable source of income through a lifetime. This is a problem most all investors are facing currently, unless of course you are so rich you can keep two and one-half million set aside just to generate enough income for Nordstrom shirts.

In summary, the stock market has started the year with a bang. However, a correction looks necessary. Sometime in the next 1-2 quarters, we estimate that the combination of higher gas prices, an over-extended market, saber-rattling in Iran and continued uncertainty in Greece will cause the market to pull back. At some point, this will be a buying opportunity which we plan to take advantage of with the cash and cash equivalents we hold for every account. So it is a good mindset to prepare yourself now for a 5%-10% pullback because they are common even in long-lived bull markets. In fact, they are necessary for markets to keep from overheating. Bottom line: corrections are normal and healthy and we haven’t had one for a while. To illustrate this point, from December 7th, 2011 through December 19th, 2011, the market pulled back just over 5%. Since then, it has risen almost 14%, as of this writing.

As always, thank you for your continued trust. Please call or email me (800-374-4412, This e-mail address is being protected from spambots. You need JavaScript enabled to view it ) if you have questions regarding the coming correction. It should not be a big one this time, given the large sum of quantitative easing underway in Europe, the United States and China.

Best Regards,

Vaughn L. Woods, CFP®, M.B.A.

*Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Delta Equity Services Corp. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0151

**Marketedge.com, Pershing NetExchange Pro, Bloomberg, Credit Suisse, Briefing.com

- http://www.bls.gov/cpi/cpifaq.htm

- http://www.moneycafe.com