I recently read an article in Investment News talking about the merits and progress of the equity indexed annuity business. For those of you unfamiliar with these vehicles, they are insurance products that credits a client’s account with an interest rate that is tied to some movement of an index. In addition, they guarantee principal protection. So, they offer some return of an index with no risk of loss. What’s not to like? Unfortunately, a lot.
The article referenced above talks about the 10/10/8 rule. These annuities should have surrender periods no longer than 10 years, surrender charges capped at 10%, and no more than 8% commission to the broker. These are huge fees and commitments that the client has to make in order to invest in these products. The question is whether the cost and restrictions are worth it. Research says no.
In 2009, an article titled “Financial Analysis of Equity-Indexed Annuities” appeared in the CFA Digest. The findings were pretty damning for equity indexed annuities. To quote the article:
In the author’s analysis, all 13 equity-indexed annuities produced returns below returns available on risk-free Treasury bills and substantially below returns available from rolling over six-month certificates of deposit (CDs) and buying five-year Treasury securities. On the basis of the Sharpe ratios, none of the equity-indexed annuity contracts produced risk-adjusted returns that were competitive with returns available on Treasury bills, CDs, or Treasury notes. The alphas for the 13 annuity contracts were all statistically significantly negative at the 5 percent level, implying that the equity-indexed annuities underperformed the market on a risk-adjusted basis by at least 1.73 percent per year, with an average underperformance of about 2.9 percent per year.
The article points out that these annuities have historically underperformed risk-free investments by a substantial margin. I see no justification to pay exorbitant fees in order to lock up your money for 10 years just to underperform a risk-free investment. Now, maybe these returns will change in the future, but until they do, investors should run, not walk, away from these products.
It has been a couple months since we’ve addressed interest rates and today we find that the 10 year treasury bond (often considered the benchmark of bond yields) has hit 3% again. With the recent economic data surprising to the upside there continues to be the possibility for rates to rise. As economic conditions improve many believe there could be a rotation out of bonds and into stocks. In addition, the Fed has recently come out with news that they are going to begin tapering their bond purchases. Many believe this is the first step that inevitably leads to raising short-term interest rates. If this occurs we would see bond prices fall and yields rise. For those investors who are thinking that bonds don’t lose value, they could be disappointed. Here is the chart of the 10 year treasury yield for the past couple years to give you some perspective:
This post is not meant to be a prediction. We have no idea where interest rates are going over the next month, year or decade. But as an investor it is important to know how rising rates could impact your portfolio. Generally, longer term bonds will get hit harder than short term. We continue to manage portfolios with caution, focusing on shorter-term bonds, as we believe that risk should be taken with your equities, not fixed income.
Of all the bear cases I have heard from investors, the one that seems to gain the most traction is the concern about what happens to the market when the Fed tapers their bond purchases and eventually begin to raise interest rates. Many believe the Fed has been propping up the stock market with low rates and once that begins to fade, the market will soon follow. While we would agree that what the Fed has done is unprecedented, we have argued before that rising interest rates may not be bad for stocks. Blackrock is out with a research piece that confirms our own prior research that stocks can hedge a rising rate environment:
So why is that? Interest rates tend to rise during times of economic growth, so while the cost of borrowing may be rising, revenue growth should be occurring at the same time. In addition, rising rates often correspond with rising inflation. Again, companies have the ability to pass through higher costs by increasing the prices of their own products. The other important item to note is the performance of bonds during these periods. While rising rates haven’t been devastating to bonds, you can see that their performance hovers around break-even. So, for those that are concerned about rising rates, please make sure you review this chart and understand that while this time may be different, rising rates have historically not been catastrophic for stocks.
There is really no indicator that we know of that can predict stock market performance. If there ever was it would very quickly be arbitraged away since markets tend to be fairly efficient. Merrill Lynch uses a metric they call the “Sell Side Indicator” to determine future stock performance. The indicator attempts to measure Wall Street analyst’s optimism or pessimism towards stocks. The theory goes that the more pessimistic analysts are about stocks, the better the time to invest. Here is the chart:
You can see, that while the indicator has come back recently, it is still at the lows of 2008 and is considered to be extremely bullish for stocks. Of more interest to me is their backtesting on this metric. As you’ll see it has better predictive power than many other common metrics:
With that being said, it still only has an R squared of .28. To give you an idea of what that means, if it had perfect predictive power it would have an R squared of 1, so it is far from being accurate. One of the best takeaways from this report is that there is no metric you can use to predict stock market performance with any degree of certainty.
Sometimes people ask me how I can be optimistic about the markets when we are dealing with things like the enormous government debt, stubbornly high unemployment, shrinking natural resources, and the cost the elderly is going to have on our population. First, every point I made in the prior sentence is also known by investors (unfortunately, I don’t have a monopoly on information). This means that much of the fear about the future is priced into the markets either through low interest rates or valuations of stocks or real estate. But there is a bigger reason I am optimistic about the future. I am in continued awe of human ingenuity. Ten years ago no one knew that Google would change the world as we know it, making information available at your fingertips. In the meantime, they have created nearly 50,000 jobs and $345 billion in wealth during this time. These innovations have been going on throughout mankind’s history. That is why I was excited about the Atlantic’s article on the 50 greatest inventions since the wheel. When you read through this list, you realize just how far we’ve come. Here are some of my favorites:
1. The printing press- brought mass productions to the written word, with the ability to get ideas into thousands of peoples hands.
8. Vaccination- probably one of the key inventions for increasing the life expectancy
9. The internet- connecting people and information in ways they never thought possible, and still going
10. Cement- the foundation of building in the world, literally
Whenever you lose faith in the investment markets, realize that the world will keep spinning and humans will keep trying to get better. This intense drive focused on getting better will continue to produce inventions over our lifetime that we can’t even dream about today. And with it, continued opportunities for investors to profit.
Read the whole list here: The 50 Greatest Breakthroughs Since the Wheel
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.