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Elmwood Wealth Management

The Year over Year Dilemma

Bob Gillooly, CFA

The U.S. stock market has improved markedly in the past few months. Numerous political and economic uncertainties in the world have been alleviated, and this has translated into an increase in investor confidence. The ‘easy money’ has thus been made, and now we move into a period where investors will crunch the hard numbers.

The challenge here is that we are still growing, but at a slower rate compared to last year. The chart at right is a good example. It shows that employment is still clearly growing in 2013, but it is not growing as fast as it was last year. In other words, the absolute or total number of jobs we are creating right now is high, but if you measure it on a relative basis to last year, the rate at which we are improving is slowing. This may seem like we are nit picking, and we are, but the stock market nit picks as well. Momentum is an important driver for the market and it is worth noting that there is some evidence of a slowing growth rate at hand.

The same challenge applies to individual companies. In the 3rd quarter of 2010, year over year earnings growth was a robust 35%. Last quarter, year over year earnings growth slowed to the low single digits. Growth is still positive, but it is another example of how the rate of improvement is slowing.

Corporate profit margins remain at very high levels, historically speaking. Higher profits mean higher earnings, and that has been a powerful driver for stocks the past few years. One of the ways companies have achieved these high profit margins has been from a general lack of spending on both capital improvements and hiring. Spending more money on new machinery and new employees is clearly what our economy wants and needs, but nevertheless it does have a short-term negative effect on margins and profitability. This is a positive development, but it is another factor that may

Quarterly Insights: April 2013

restrain earnings growth near term and thus take some momentum out of the stock market.

Our Investment Strategy

Though there have been many positive developments of late, short-term investment risk has risen above our comfort levels. We have been reducing high volatility stocks in favor of those with more stability. We are also reducing foreign emerging market exposure, mostly through a reduction of investments in China. This will further reduce high risk, high reward situations. In the intermediate term, we remain positive and feel there are ample opportunities for investors. We are particularly interested in building up additional exposure in the health care and energy sectors, as we have little doubt these areas will become an increasingly larger part of our economy. In the last few years, corrections in the market have typically lasted two to four months. We have no reason to believe at present it will be any different this time around.

Employment is growing, but at a slower rate




Cash Creep: The Unwelcome Anchor

Steve Caltagirone

Many financial advisors consider cash to be a vital tool in the ongoing management of an investment portfolio. In periods of economic illness, the philosophy of “Cash is King” is often adopted across both corporate balance sheets and investment portfolios. During a correction or deeper bear market, cash can serve as a shock absorber, shielding a portfolio from greater levels of downside exposure. Just the opposite, when economic skies clear and financial markets rally, cash can quickly take on the form of an unwanted anchor, preventing a portfolio from realizing its full potential.

Throughout a given market cycle, it isn’t uncommon to find an advisor holding cash balances that range as high as 10-20% of a portfolio’s total asset value. Surprisingly, higher cash weightings are not always dictated by the fear of a looming downturn in the market. The routine practice of portfolio adjustments can often lead to the accumulation of higher cash balances, otherwise known as cash creep. If not monitored frequently, portfolio cash creep can and will transition from a short-term active decision to a long-term portfolio strategy. In the process, valuable income is left on the table.

Cash used to play a meaningful role in the growth of a diversified, multi-asset class portfolio. As the chart at right illustrates, that role diminished quickly when the global financial crises hit full stride in 2008. In response to the crises, interest rates on cash quickly plummeted to the 0 – 0.25% level. Four years later, this rate remains intact with every indication it will continue into 2014. When advisors allow cash levels to drift higher in today’s environment, they are essentially betting on a pending fall in the market. After all, a 0-0.25% return can only beat negative returns in the market. There simply isn’t room for any other competing positive returns. In addition to providing clients’ peace of mind, advisors often hold higher cash balances in anticipation of sunnier skies ahead.


But what if those blue skies aren’t apparent for six months or even a year? With the assortment of highly liquid, inexpensive fixed income products throughout the marketplace today, advisors have numerous options for finding better alternatives to cash. The fixed income universe provides numerous choices for stable, low risk yields in excess of what is currently offered in the cash market. At Elmwood, we believe cash should be kept to a minimum throughout all market conditions*. The fixed income universe simply provides too many choices for stable, low risk yields in excess of what is currently offered in the cash market.

We encourage clients to regularly monitor cash balances in portfolios outside of our management. Portfolio cash creep can settle in quietly, but quickly. Ensure that your portfolio is not dragging an unwelcome anchor for an unusually long period of time.

*Assumes a minimal need for portfolio income or expenses.




Does Your Retirement Plan Address the Cost of Healthcare?

Shannon S. Lemon, CFP®

Most of us will spend our entire lives saving for retirement. As the date draws near, a great deal of planning will go into trying to figure out where to live, how time is spent, when retirement actually begins, and which resources will ultimately be used. What few people actually think about and plan for is the cost of healthcare; it is usually not a driving factor or a consideration in their retirement planning.

The cost can be shocking. As seen in the chart, the Employee Benefit Research Institute “EBRI” estimates that men retiring in 2012, at age 65, will need $185,000, to have a 90 percent chance of having enough money to cover health care expenses (excluding long-term care) in retirement. For women, the cost is even more substantial at $210,000. Medicare only covers 60 percent of the cost of health care services; most retirees pay for a supplemental plan. With the annual cost of healthcare increasing at a rate of 5-7 percent per year, the total cost can be astonishing. Ultimately, it does not make sense to talk about retirement savings without talking about health care expenses.

Here are some questions that should be discussed when you are considering retirement:

How do my current benefits work? When I retire, does my spouse/partner or I have any retiree health insurance?

If I retire before age 65, what will I do for my healthcare coverage? Will I have another source of health care insurance from a spouse/partner or use Cobra or some other plan to bridge the gap until I am eligible for Medicare?

How is my health? What is the health history of


my family? Knowing what health risks are present can help act as a guide to determine how much additional health care costs you may encounter in retirement.

What are my Medicare options, what does Medicare cover and what is the cost? Knowing what is covered with basic Medicare (Part B) will help determine the type of supplemental policy (Part C) you may need or want. What is the basic coverage for the prescription drug plan (Part D)?

When should I begin taking Social Security? Does it make sense to begin taking it early, at retirement age, or at age 70?

How many years will I be in retirement? Upon retiring at age 65, men on average will live another 18 years and women will live another 20 years.

Should I consider long-term care insurance?

If you haven’t asked the questions or know the answers, it may be time to update your plan.

Source: JP Morgan





Investment Theme: U.S. Energy Resurgence – Not only has there been a tremendous amount of natural gas discovered in America, but new technology has led to a boom in new oil discoveries as well. The abundance of new energy will mean our country must invest in virtually every aspect of our energy infrastructure to make this resource available.

Elmwood’s Strategy: We are investing in companies that have large underground reserves of both natural gas and oil. We are also taking advantage of less obvious ways to exploit this theme. For example, companies which help clean up gas and oil wells, and transportation companies that move both supplies and the commodity itself across the country.

Investment Theme: Total Return Equity Investing – Total return takes into account both price appreciation and dividend payments. Companies are increasingly raising dividends and buying back stock as a return to shareholders.

Elmwood’s Strategy: Look for companies that have the cash flow to both buy back their own stock and increase their dividend. If a company bought back 2% of their outstanding shares annually and paid a 2% dividend yield, your total return would theoretically be 4%. This is a great backdrop in any circumstance.

Investment Theme: U.S. Health Care Needs – With new health care legislation now in place, approximately 40 million individuals will become eligible for health care coverage. This fact, coupled with the aging baby boomer demographic will create substantially more demand for health care going forward.

Elmwood’s Strategy: An increase of both the number of participants and the frequency of accessing health care inevitably will drive up the cost to cover this phenomenon. The investment opportunity lies within companies that benefit by serving a larger number of participants, yet are able to help reduce the cost of service. Insurance, benefit management, and product distribution companies all look well positioned here.

Elmwood’s Strategy: We take a more active approach to our bond portfolio. We are buying high current income corporate bonds (6-7%) with good credit quality, yet are relatively short in maturity. Some of these will likely be sold before maturity. We are also using higher income paying preferred stocks (6%) that offer more favorable tax treatment as a substitute for longer maturity bonds.

Investment Theme: High Current Bond Yields – Yields for most good quality bonds are extremely low. Yet there is a segment in the market where you can buy both high quality and high current interest paying bonds.

Investment Theme: Mortgage Backed Bonds – The housing market has found a bottom and default rates are declining. Should interest rates rise, these bonds typically perform better than most.

Elmwood’s Strategy: Investors have been reluctant to re-engage with the mortgage bond market since the financial crisis. Much of this risk has been accounted for and there is an opportunity to find higher yields.


Elmwood Wealth Management 2027 Fourth St., suite 203

Berkeley, CA 94710 (510) 858-2723

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www.ElmwoodWealth.com

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