Stock and bond ETFs reverse recent trends

Economic data on the rising unemployment rate and corporate missed earnings appear to have contributed to the recent reverse of the upward trend in stock ETFs. This post explores this and other recent trends by highlighting selected ETFs that passively track major stock and bond indices.

NASDAQ market correction

As this WSJ article recently highlighted, the NASDAQ (ticker: QQQ) is officially in “correction” territory now. We define a correction as when prices drop by more than 10% from a recent high. Missed expectations from major investments in Artificial Intelligence by tech leaders Microsoft and Alphabet may have contributed. Nevertheless, the S&P 500 index ETF (ticker: IVV) is still up over 12% year to date, as the chart below illustrates. While returns for these two stock ETFs are lower than their mid-year peak, they are still good relative to other markets, like bonds.

Recent trends in stock and bonds ETFs.
Stock ETFs recently started a downward trend, but bond ETFs started an upward trend.

Recent trends in Bond ETFs

Investors appear to be quickly moving away from stock ETFs and into bond ETFs. This so-called “flight to safety” is clear in the image above in the recent upward trends in bond ETFs. The intermediate-term bond ETF, iShares Core U.S. Aggregate Bond ETF(ticker: AGG), shows some of this new trend. This trend is amplified when a longer-term bond ETF, like iShares 20+ Year Treasury Bond ETF (ticker: TLT), is viewed.

What is next?

The Fed left short-term interest rates unchanged after meeting this past week. But, a rate cut is looking more likely, as inflation is down to 2.5% now, edging closer to the Fed’s target of 2%. The Fed’s next meeting is in September, so investors will be eagerly awaiting the outcome of this important meeting. In the meantime, investors may continue to invest in bond ETFs to potentially hedge any additional losses in stock ETFs.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs

Inflation trends

The Federal Reserve’s recent announcement to hold short-term interest rates at 5.25-5.5% was well received by the markets this past week and was clearly influenced by inflation trends. After the S&P 500 recently fell into a “correction”, defined as a 10% drop from a recent peak, the index returned over 5% last week. In this post, we highlight recent inflation trends towards lower rates and note that there is still some work to do to reach the Fed’s target inflation of 2%.

Inflation over the last 12 months

According to Statistica.com, the 12-month inflation rate was 3.7%. As the chart below shows, this is a significant reduction in peak inflation of over 9% in June 2022. This reduction was largely due to seven quarters of increasing short-term interest rates, which should reduce economic activity by increasing borrowing costs. But, the Fed also has a mandate to keep unemployment low.

Monthly 12-month inflation rate in the United States from September 2020 to September 2023.
Monthly 12-month inflation rate in the United States from September 2020 to September 2023.
Source: Statistica

Unemployment and a soft landing?

Unemployment has stayed low, as the next chart shows.

Monthly unemployment rate

It is our opinion that the Federal Reserve appears to be close to reaching its goals of low unemployment and inflation. And, this all appears to be happening without triggering a recession. Our final chart shows GDP, which when its rate is negative for two quarters, is the official trigger for a recession in the U.S. As this WSJ article notes, the U.S. economy is “Improbably Strong”.

Real GDP

We conclude from these macroeconomic indicators that the U.S. economy, inflation, and unemployment appear good for now. With the year nearly over, we will see very soon how consumer sentiment and consumer spending around the holidays may influence these indicators.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs

Inflation and ETFs

Inflation continues to persist higher than its long-term norm. Very few sectors of the U.S. economy have performed well. In this article, we discuss how ETFs designed with inflation in mind have fared in this current economic environment.

Historical rates of inflation

The U.S. Bureau of Labor Statistics (BLS) is an excellent free source of historical rates of inflation. The image below shows this data for the last 20 years. Clearly, the current inflation rate is above the norm of 2-3%. However, it does appear to be down somewhat from its high in June. Fortunately, we don’t see any recent “grey” area in this chart, which represents the U.S. in a recession, as determined by the National Bureau of Economic Research.

Inflation rates are still elevated above their long-term norm, but off of recent highs from June 2022

ETFs to protect against inflation

We chose three ETFs to show that not all ETFs are created equal in addressing inflation. Here, the acronym “TIPS” stands for “Treasury Inflation-Protected Securities”.

  • iShares Barclays TIPS ETF (ticker: TIP), $25B in assets
  • SPDR Bloomberg Barclays 1-10 Year TIPS ETF (ticker: TIPX), $1.4B in assets
  • Vanguard Short-term 0-5 year Inflation Protected ETF (ticker: VTIP), $17B in assets

    The most significant difference in these three ETFs is the term to maturity of the bonds contained within them. This difference has led to very different total returns for these three ETFs in 2022, as shown below.

    2022 Year-to-Date Total Return of Three ETFs offering inflation protection

    So, what’s going on?

    As one of my favorite writers at the Wall Street Journal recently wrote about, rising short-term interest rates are having greater impacts on the price of longer-dated bonds. This impact includes treasuries with inflation protection which each of these ETFs contains. The weighted average maturities for these three ETFs are 7.4 years, 4.7 years, and 2.5 years. By comparison, the broad-based iShares Core U.S. Aggregate Bond ETF has a weighted average maturity of 8.7 years and is down about 11% in 2022. So here, we see the limitation of a fund, like an ETF, that maintains a steady average maturity. Rising interest rates are offsetting the inflation benefit. Unfortunately, investors can avoid this with a bond ladder, but doing so requires investors to leave the relative ease of investing in ETFs.

    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
    ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs

    Inflation Hedging

    Inflation hedging continues to be of great interest for investors large and small. In this post, we quantify some possible ways to combat inflation based on a recent article in the WSJ.

    Historical Inflation Trend

    Inflation is currently around 6%, well above the 2% rate seen recently. The chart below shows how most of this change occurred in 2021. This rate is well above the 2% long-term target set by the Federal Reserve. So, what are some options for investors in this current inflation climate?

    Inflation is about 6% in late 2021

    Treasury inflation-Protected Securities (TIPS)

    TIPS are one of the most obvious places investors look for inflation hedging. The iShares TIPS Bond ETF (ticker: TIP), with over $30 billion in assets, is a popular option. This ETF has performed notably better than a broad bond benchmark, like the iShares Core U.S. Aggregate Bond ETF (ticker: AGG), as the chart below illustrates. Note that while TIP has slightly higher volatility than AGG, it performance in 2021 is noticably better. In fact, according to ETFReplay.com, the 2021 year-to-date return of TIP is 5.4%, versus -1.0% for AGG.

    Commodities

    There are certainly other options investors can consider. For example, investors often seek commodity investments when inflation rises. This recent study by Vanguard indicated that a 1% rise in inflation could produce a 7-9% rise in commodities. This estimate looks surprisingly accurate, as the ETF DBC (PowerShares DB Commodity Index) should be up 28-36% in 2021, given the inflation rate increase this year from 2% to 6%. In fact, DBC is up 32.7% in 2021, according to ETFReplay.com

    Updated optimal portfolios

    For subscribers of our ETF optimal portfolios, we encourage you to log in to see the latest updates. Note that, based on our latest backtesting, monthly portfolios change more quickly now to respond to market dynamics.

    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

    Upgrades to our Optimal Retirement Income Calculator

    As promised, our free optimal retirement income calculator continues to improve based on your feedback. Thank you to everyone who has provided suggestions by contacting us! In this post, we highlight some of the most recent enhancements to this free online resource.

    A Glide Path?

    The term “Glide Path” is used to refer to shifting from one asset to another. Previously, our optimal retirement income calculator kept a retiree and their spouse’s asset allocation fixed. For example, our calculator previously maintained a fixed allocation (e.g. 60% stock and 40% bond) each year by drawing down accounts appropriately. Unfortunately, such an assumption is not entirely realistic. Instead, many retirees may wish to slowly reduce their “riskiness” in stocks and increase their “safety” of bonds during retirement.

    A typical retirement glide path reduces portfolio risk each year. Photo by Pixabay on Pexels.com
    A typical retirement glide path reduces portfolio risk each year. Photo by Pixabay on Pexels.com

    One percent is a typical glide path, meaning that a retiree who is 60 years old starting with an asset allocation of 60/40 (stocks/bonds) will shift their asset allocation to 59/41 at 61 years old, 58/42 at 62 years old, and so forth.

    Our optimal retirement income calculator now includes a glide path to transition from stocks to bonds during retirement.
    Our optimal retirement income calculator now includes a glide path to transition from stocks to bonds during retirement.

    Other updates to our optimal retirement income calculator

    We also updated a number of the default values used to better reflect “typical” retiree demographics, as well as expected macroeconomics and capital market conditions. The list below summarizes these default changes.

    1. Retiree and spouse default ages changed to 65 and 62. This difference of three years is consistent with the average difference in retiree and spousal ages.
    2. The long-term rate of return of stocks and bonds set to 7.2% and 4%, based on the lifetime annualized returns for our stock and bond ETFs IVV and AGG.
    3. We set the retiree’s fraction of cost basis for stocks/bonds assuming a 10-year gain at their long-term rates. So, the cost basis for stocks stayed at 50%. But, the cost basis for bonds increased to 68%, since over 10 years, bond capital gains and reinvestment of dividends would yield a higher cost basis.
    4. Inflation rate set to 2.1%, based on an AR(1) stochastic process model and annual CPI (consumer price index) data from 1992-2020.

    We hope you find these updates helpful as you plan for your financial future! Please stay tuned as there are still several suggestions we are still working on that will appear in the coming months.

    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

    Presentation to over 1,800 financial advisors on retirement drawdown strategies

    A webinar attended by over 1,800 financial advisors recently featured ETFMathGuy to discuss retirement drawdown strategies. Subsequently, the Retirement Income Journal wrote about this event. In this posting, we will discuss some of the highlights of this webinar. Please click the image below to view the 60-minute webcast. Or, you can browse the slides.

    Webcast recording: A Deep Dive Into Retirement Drawdown Strategies.

    Webinar highlights

    As the title of the webinar indicated, its emphasis was on retirement drawdown strategies. Our host, Steve Parrish discussed some of the recent changes to Required Minimum Distributions (RMDs) that resulted from the SECURE Act, as well as where tax law may go in the future. Steve also wrote a really nice article recently in Forbes entitled “Three Reasons to Take Your RMDs Now“. Joe Elsasser, Founder and President of Covisum, a FinTech company specializing in retirement drawdown strategies, also presented. Joe showed how his firm’s software can identify the so-called “tax torpedo“, and assist retirees on how to plan accordingly.

    After that, I discussed two research articles on retirement drawdown strategies. To begin, I quantified the impact of eliminating the stretch IRA for non-spouse heirs, which I highlighted in a previous ETFMathGuy posting. The key takeaway from this peer-reviewed article was that there is still a benefit to an heir to stretch their IRA drawdowns over the 10-years permitted by the SECURE Act. Doing so can increase the heir’s inherited assets by 11-17%, depending on their specific situation.

    Emerging Research

    I also spent a portion of my presentation to this large group of financial advisors discussing some of my latest research. This recent work builds upon some of my previous publications with Dr. Dan Ostrov at Santa Clara University. In this latest research, I identified the use of the Common Rule as a diagnostic for the next stage of optimal decision making for retirement income. The image below summarizes the preliminary findings for three categories of retirees.

    The sensitivity of optimal drawdown strategies for three categories of retirees. Forthcoming research by DiLellio and Simon (2021)

    Thank you for your feedback

    I would like to thank the many financial advisors who recently tried out my retirement calculator. So, I am logging all these helpful suggestions for improvements. I hope to have this free calculator updated shortly that begins to incorporate many of these suggestions. I will discuss some of the calculator enhancements in a future post.

    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETF efficient portfolios.

    New Features in our Optimal Retirement Income Calculator

    Recently, we discussed our free web-based calculator to help you better plan for your retirement. At that time, it offered answers to the many commonly posed questions for those nearing or currently in retirement.

    • How long will my portfolio support my discretionary and non-discretionary expenses?
    • How much will my heir or favorite charitable organization receive?
    • What will my future tax liabilities look like?

    Now, our calculator includes many new features to address a broader group of retirees, especially those with a spouse or domestic partner with other sources of retirement assets or retirement income.

    The Optimal Retirement Income Calculator by ETFMathGuy.com has many new features
    The Optimal Retirement Income Calculator by ETFMathGuy.com has many new features

    New Features

    The newest version of our retirement calculator offers a better interface for inputs, by arranging them in logical groups. It also includes many new features relevant to many retirement plans.

    • A separate retirement horizon for a surviving spouse (or domestic partner) and their unique after-tax retirement income needs
    • New inputs for the spouse’s tax-deferred accounts, like Traditional IRAs, Rollover IRAs, 401(k)s, 403(b)s and 457 plans
    • New inputs for the spouse’s tax-exempt accounts, like Roth IRAs, Roth 401(k)s and Roth 403(b)s
    • An option to select your state of residence, so that the taxable brokerage account can be properly taxed whether (or not) the surviving spouse resides in a community property state
    • Added a starting age for social security and pensions for the retiree, and if applicable, their spouse, to delay these other sources of retirement income.
    • Input to choose whether (or not) to value the heir’s assets based on using the new 10-year inherited IRA stretch rules due to the SECURE Act.

    Optimizing Retirement Income Withdrawal Decisions with a Spouse’s Contribution

    Like the previous version, the calculator provides results using the Common Rule and our Optimal Rule. To develop a plan for a hypothetical couple, we used the default values in the calculator, but switched the input labeled “Do you have a spouse or domestic partner?” to “yes”. In this case, you would received the following summary of your plan.

    Plan summary example when a spouse or domestic partner is included in the Optimal Retirement Calculator from ETFMathGuy.com
    Plan summary example when a spouse or domestic partner is included in the Optimal Retirement Calculator from ETFMathGuy.com

    Scrolling down the page, you will see the a forecast of withdrawals to meet this hypothetical couple’s after-tax retirement income needs. In this case, we assumed a 20-year retirement horizon for the retiree. Then, the surviving spouse lives an additional five years after the retiree passes away. Consequently, in years 21-25 of retirement, the surviving spouse is no longer filing their taxes as “married filing jointly“. Instead, their tax brackets are significantly lower in these later years with a filing status of “single“.

    Our updated optimal retirement income calculator now includes results for a surviving spouse (or domestic partner)
    Our updated optimal retirement income calculator now includes results for a surviving spouse or domestic partner .

    The updated retirement calculator also tracks account balances, and now includes the spouse (or domestic partner) accounts as dashed lines.

    Account balances now include spouse or domestic partner accounts.
    Account balances now include spouse or domestic partner accounts.

    We hope you find these new features helpful as you plan for your retirement! This new calculator continues to improve, and we welcome your suggestions.

    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

    The SECURE act and Your Retirement

    On December 20, 2019, the SECURE act (Setting Every Community Up for Retirement Enhancement act) was signed into law. This new law made a number of changes that could effect your plans for retirement. We discuss a few highlights of this new law in this post.

    New age for Required Minimum Distributions (RMDs)

    The SECURE act recognizes that more individuals are delaying retirement. So, the new law changes the age to take initial RMDs from tax-deferred accounts, like 401(k)s, 403(b)s and traditional IRAs. Previously, initial RMDs were triggered in the year you turned 70 1/2.

    Required Minimum Distributions (RMDs) are changing.
    Tax laws for retirement are changing. source: Getty Images

    The new age under the SECURE act is 72 for individuals who reach 70 1/2 in 2020. Using a handy online age calculator or performing a little mental math, that means anyone born after June 30, 1949 can wait until the year they turn 72 to take RMDs.

    How will this new RMD age affect your retirement plan?

    In late 2019, we developed a retirement calculator that included income and capital gains tax forecasts. It also included RMDs under the old law. We are happy to announce we have updated our calculator to include this new law. Please check it out! We also added a tool tip for each input in the calculator, to help you better understand how the model works.

    We updated our retirement calculator to include the age change of RMDs from 70 1/2/ to 72.

    Bad news with the SECURE act

    Unfortunately, there is also some bad news for retirees coming from the SECURE act. The so-called “Stretch IRAs” are now not nearly as valuable as they were prior to this law. Previously, IRAs that are passed to nonspouse heirs could be withdrawn over their life time. This feature made inherited IRAs very appealing to younger heirs, who could stretch their payments, limit their income taxes, and stretch pre-tax gains over a longer time. The new law limits this time to 10 years. In a bit of good news, this law does not affect existing inherited accounts.

    Conclusions

    Tax law will continue to change. We shouldn’t expect congress to continue to keep the taxes status quo. Instead, current and future retirees should consider diversifying their retirement income sources to accommodate possible future changes.

    July 2019 optimal portfolios are now available and discussed in terms of recent and long-term market trends

    The July 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, please log in and select your discount broker. In this post, we will also discuss more about risk and return in an optimal ETF portfolio.

    As we mentioned in our last post, there are benefits to having more ETFs to choose from during the portfolio construction process. We showed the potential to increase expected returns. In this post, we highlight another important element – risk.

    Risk and Return

    Risk and return are two fundamental issue that are important to consider when investing in an ETF portfolio. The chart below shows risk (horizontal axis) and return (vertical axis). Here, we define risk as the annual volatility, measured by the standard deviation of daily returns. We evaluate risk and return using a multi-year sample period selected from our rigorous backtesting process. As this chart shows, the optimal portfolios reside at risk levels between the bond market (ticker: AGG) and stock market (ticker:IVV). And, these portfolios are efficient, since they were selected to maximize the expected return.

    Risk (Volatility) and Expected Return in the July 2019 optimal portfolios.   Notice that at each risk level (conservative, moderate and aggressive), different ETFs offered by different discount brokers leads to different expected returns.
    Risk (Volatility) and Expected Return in the July 2019 optimal portfolios. Notice that at each risk level (conservative, moderate and aggressive), different ETFs offered by different discount brokers leads to different expected returns.

    As this chart shows, cash can be nearly risk-less, based on volatility, but offers returns that may not exceed long-term inflation. Bonds can offer more of a potential return, but with added risk. Even more return is possible from the stock market for those willing to accept additional risk.

    What about the last 6 months?

    Indeed, it is true that the first half of 2019 has been very good for both stocks and bonds. Based on a recent Wall Street Journal article, “… S&P 500 finished Friday up 17% this year, marking its best first half since 1997 “. According to the site ETFreplay.com, and including dividends, the stock and bond market are up 18.3% and 5.8%, respectively, this year. Will this trend continue? I personally doubt anyone really knows, as I believe that markets are generally very efficient. A better question may be “What level of risk” or “How much exposure” do you want your investments to have in various parts of the market. To end this post, I’ll leave you with one (of many) famous quotes by Warren Biuffet.

    “The stock market is a device to transfer money from the impatient to the patient.”

    Warren Buffett

    We hope you found this post educational!

    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

    ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

    Your Retirement Nest Egg

    In a recent issue of the Wall Street Journal, there was an excellent retirement article. In it, the author responded to a reader’s question “How much does my nest egg need to be?”. Your retirement nest egg is very important! So, we prepared a summary and some additional insights to consider. Our perspective is drawn, in part, from our award-winning research on retirement income planning.

    retirement nest egg

    Article summary by ETFMathGuy

    The article starts with predicting your expenses. This is arguably a difficult task, and where many people stop. But, without this information, there is really no way to estimate the “right size” of a retirement nest egg.

    In summary, the article suggests the following calculation.

    1. Start with an estimate of your expenses. A common approach to this is to assume a percent between 60-80% of expenses pre-retirement. This approach assumes that your expenses go down in retirement. That may be true for many retirees, as they no longer have mortgage payments or dependent expenses. Of course, a more precise estimate can be done.
    2. Subtract from this any guaranteed income, such as social security and after-tax pension benefits or annuities.
    3. Take this difference and multiply it by 25. In this article, they assume that a 65-year old lives until 90. This age is a conservative estimate, based on information from the Social Security Administration.

    What isn’t stated in the article about your retirement nest egg

    While I enjoyed this article, it made some assumptions about your retirement nest egg. For instance, the suggested value doesn’t include uncertain investment returns or inflation. The net effect of including both of these would typically give a retiree more years of retirement income. The extra income would come from a conservative investment in retirement, less inflation. Using a 4% conservative after-tax average return and 3% average inflation, this net effect would provide a 1% gain (on average) each year.

    We hope you enjoyed our commentary! If you would like to see more like these, please send us a message.