Is Europe Cheap?

Europe can’t seem to catch a break.  The last several years have seen both financial and sovereign crisis throughout Europe.  The latest victim is Cyprus, which has its own banking crisis in which the fallout seems like it will be horrific.  With recession gripping many countries in Europe and the continuous bad news coming from that region, you would expect their stock market to have performed equally poorly.  In fact, the European stock index is about flat for the year.  Unfortunately, this occurred during a period where the US stock market is up around 9%, so comparatively speaking, performance has been lackluster.

Always intrigued by underperforming, potentially cheap, areas of the market, we took a closer look at Europe.  Below is a chart put out by Guggenheim showing the dividend yield of stocks vs. bond yields in Europe.  It is rare for the dividend yield to exceed the bond yield, but that is the case now, by a wide margin.  In addition, absolute dividend yields on European stocks are around 4%. 

One of the concerns for most investors is how bad Europe could get and whether the economy could further infect stock prices.  When you dig deeper into European stocks, you find that many are multi-national and derive a substantial portion of their income from non-European countries like the United States.  The top 5 stocks held in the Vanguard European ETF (ticker VGK) are huge companies with revenues coming from all over the globe:  Nestle, HSBC Bank, Novartis, Roche, and BP. 

With regards to European valuations, a recent article in CNBC talks about how inexpensive Europe is right now:

European stocks’ discount to U.S. shares is one of its biggest of the past decade, based on revenues. S&P 500 companies trade at 1.4 times their expected sales over the next 12 months against a EuroSTOXX 50 ratio of 0.7 times.

“On price to sales, which we’d argue is one of the more useful measures for doing international comparisons, the U.S. has become noticeably more expensive than other markets versus its own history,” Baring AM’s Mahon said.

Valuations in Europe look compelling compared to other markets around the world.  We believe the risks in Europe are balanced by the valuation discount and investors should maintain exposure to this area of the market.  The best protection from risk is valuation.

Surviving an Inheritance

There was a very interesting article in the Wall Street Journal about how damaging inheritances can be for a family.  Unfortunately, I have seen this first hand and it is not a topic I have heard discussed enough.  Here are some of the statistics from the article:

  • 70% of inheritance is depleted by the 2nd generation.

  • 90% of inheritance is depleted by the 3rd generation.

  • 2/3rds of baby boomers will inherit family money over their lifetime to the collective sum of $7.6 trillion.

The article references the famous quote, “Shirtsleeves to shirtsleeves in three generations”.  Why is this happening? My own anecdotal experience shows that the once the younger generation inherits the wealth, spending increases.  This could be for any number of things- new car, house, country club membership, etc.  The idea is that they are going to enjoy some of this new found wealth, but it will be temporary.  But habits are formed quickly, and it is hard to turn off the spending, especially when you get accustomed to “the good life”.  The exact same phenomenon happens with lottery winners.

If you have been blessed enough that you are able to leave a sizable estate to your children, it is imperative that you think through how that wealth might effect them.  Having frequent discussions about the importance of work and accomplishment coupled with learning life lessons for themselves can help your children avoid potential disasters.  If you are not careful, what is thought to be a blessing for the next generation can turn out to be a curse.

Largest Pension Fund Considers Exiting Active Investments

It is a commonly held belief that the more money you have, the more exotic your investment strategy should be.  The story goes, all the best money managers have significant account minimums which is why only the wealthiest individuals or largest institutions have access to them.  Unfortunately, there is no data that can back up this assertion and it seems like the investment community is finally catching on.  The $255 billion California Public Employee’s Retirement System (Calpers), one of the largest institutional investors in the world, is considering whether to completely abandon active managers in their portfolio.  Here is an excerpt from the article:

Over the past 10 years, just 38% of large-cap-equity managers have beaten the S&P 500. Over five years, it shrinks to 31%, and over three years, it is just 18%, according to Morningstar Inc.

Making things even harder for those trying to pick active managers is that just 9% of large-cap managers outperformed the S&P 500 over all three time spans.

The inconsistency of actively managed returns is what prompted the review by CalPERS.

As P&I reported: “CalPERS investment consultant Allan Emkin told the investment committee that at any given time, around a quarter of external managers will be outperforming their benchmarks, but he said the question is whether those managers that are doing well are canceled out by other managers that are underperforming.”

The only surprising fact about this article  is that it took this long for CalPERS to consider making this change.  The data is overwhelming and the risk of underperformance is just too great to try to hire managers that outperform.  CapPERS spends millions of dollars per year hiring consultants and researching this topic.  For those of you who are implementing an active strategy (either on your own or through outside managers), the question you need to ask your self is whether you will have more success than they do trying to find the next hot manager.

Source:   Passive investing: If it’s good enough for CalPERS …

Household Net Worth At All-Time High

The Federal Reserve has reported that US Household’s net worth recently hit an all-time high.  I really didn’t see much in the press about this, but it is worth noting.  Our own anecdotal evidence from tracking the net worth of our clients suggest this to be true as well.  Here is the chart from Scott Grannis showing the growth/contraction in the composition of net worth:

So why is this important?  First, debt levels have stabilized with no real growth over the past 5 years.  This is also at a time when interest rates have fallen dramatically.  This means that consumers are spending less of every dollar on debt servicing.  The ability for consumer spending to continue to power this recovery is still in place.  Second, the “wealth effect” can take hold.  When consumers see the values of their homes and bank accounts increase, they feel wealthier and therefore have a tendency to spend more.  There are still problems in our global economy, but it is hard to look at this chart and argue that US consumers haven’t recovered.


Roth Conversions Under Attack

Yesterday, the House of Representatives narrowly approved Paul Ryan’s budget. While the Senate quickly rejected this bill, one of the provisions seems to have bi-partisan support, and that is reforming the tax code.  Many politicians have been advocating lower tax rates for all Americans in conjunction with eliminating deductions.  Ryan’s budget calls for the elimination of deductions and simplifying the tax code to two rates, 10% and 25%.  While this may be somewhat revenue neutral, it would simplify the code making it easier for everyone to complete their tax return.

Unfortunately, if something like this gets through Congress it could have a real impact on those taxpayers who have chosen to convert their IRA accounts to Roth IRA accounts over the past several years.  Let’s review how this works.  Currently, when I convert my IRA to a Roth IRA, I pay taxes today on the conversion amount.  In return, all of my IRA funds go into a vehicle (Roth IRA) that will be tax-free for the rest of my life.  Why would I do this?  Mainly, if I think either a) my income will be the same or higher in retirement and/or b) my tax rate will be the same or higher in retirement, then Roth IRA conversions could make sense.  You would pay taxes now at a lower rate versus waiting and paying taxes at a higher rate in the future.

This second point has been one of the driving factors why Roth IRA conversions have been gaining popularity.  The thought process is that the government has a debt problem and at some point tax rates will have to go up in order to pay for this massive debt.  Case in point, Congress allowed taxes to go up on wealthy Americans this year by not extending the Bush tax cuts.  But this budget proposal could nullify all of the value that individuals who converted to Roth IRAs thought they were gaining.  Tax rates would go down, not up, and deductions would be curtailed.  If I converted my IRA to a Roth IRA because I am currently in the 25% tax bracket and I will be in the 28% tax bracket in retirement, I would be extremely upset if the new tax law finds my marginal tax rate at 10%.  I will have essentially paid tax at a high rate to convert my IRA to a Roth IRA, only to find that if I had kept my IRA intact, I could have paid taxes at a much lower rate in retirement.

Tax planning well into the future is difficult because we have no idea what the laws may look like.  It would be wise for individuals to consider all of the risks (including legislative) when planning for the future.

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.