2016 Q3 Quarterly Commentary

Interest Rates are Low?  Who Knew?  

The chart below shows the change in the interest rate of the 10 year Treasury bond over the last 34 years.  The early 1980’s were the tail end of a period of high inflation and interest rates.  Many of you probably remember having CD’s paying interest in the double digits.  In 1981 policies were enacted by the Federal Reserve that started a drop in interest rates that, as the chart below shows, has not really ended since.  Earlier this year the interest rate on the 10 year treasury hit a record low…the US has never seen interest rates this low.   In fact, if you put it in a broader historical context the current interest rate environment is the lowest the world has ever seen.  We won’t bore you with the details of Grecian, Roman, Byzantine and British Empire interest rates but it is true – interest rates have never been this low.  

The real effects of this on people’s lives are clearly visible.  On the positive side home, vehicle and unsecured financing is inexpensive.  This has allowed people to free up cash flow by reducing their interest costs and households have been slowly reducing their debt the last few years.  Total household debt relative to US Gross Domestic Product is the lowest it has been in over a decade. 

However, the negative consequences of low interest rates are starting to weigh heavily on investors and the economy.  Our economy is built upon a system of credit and interest and it is becoming apparent this system is impaired in a low rate environment.  Banks rely on the ability to lend money out for more interest than it costs them to hold it (net interest margin).  As interest rates entered into unprecedented lows their margins shrank and now depositors receive little to no interest while paying fees on their accounts.  Similarly, insurance carriers rely on interest payments from a bond portfolio to reduce premium costs and increase profits.  As income received from their investment portfolios have decreased insurance premiums have increased.  Pension funds who had generally counted on – foolishly in our opinion – an 8% annual rate of return to pay future liabilities are now facing a reality where 40% of their portfolio is only earning 2% – or less – interest.  That makes it kind of hard to earn the 8% they – and their pensioners – are counting on.  While low interest rates may have assisted in the avoidance of a total economic collapse if they continue too long our economic system may slowly break down.

What we think is more likely to happen is an attempt to return to normal via central bank raising interest rates. We have been waiting for this for a long time.  Admittedly, this low interest rate environment has lasted far longer and been more extensive, than we expected.  It could continue to go on longer than we expect.  But the commentary among the “economic and political elite” has begun to change.  The US Federal Reserve is receiving a lot of pressure to normalize rates and it appears they may resume that process soon.  

A World with Rising Interest Rates

This creates a very real risk to investors.  There is an inverse relationship between interest rates and the value of a bond.  If interest rates go down – like they steadily have for 30 years – then the value of a current bond goes up.  If interest rates go up then the value of a current bond goes down. Once this process of raising rates begins bond holders will be dealing with something they have not had to deal with in 30+ years – the value of their bonds going down.    

As Jack would remind us, the way people invested when he started as an investment manager 40 years ago this would not matter.   People would purchase a bond by directly lending the US Government or a company $10,000, for example, collect interest for 10 years and then at the end 10 years the entity would give them back their $10,000.  Whatever happened to the price of the bond along the way did not matter.  The investor got their $10,000 back at maturity no matter what the value of the bond did.  

But it does not really work like that anymore.  30 years of decreasing interest rates, an industry “scaling” their business models to maximize profits, and the creation and adoption of Modern Portfolio Theory (the en-vogue investment management theory of the day) have essentially changed how individual investors access the bond market.  Investment products have been designed and built around a bond market that steadily increases in value. The principal protection element of bonds (you get your $10,000 back the end of 10 years) has been at best limited and at worst eliminated through the management style of bond funds.  Bond fund managers rarely (very rarely) hold a bond till maturity.  In fact, the execution of a portfolio following Modern Portfolio Theory results in the creation of divided bond classes grouped by the maturity date of the bond.  This grouping forces the manager to sell their bond holdings prior to maturity, even it has to be sold at a loss. 

With the winds of change upon us we are being forward thinking in how to manage a bond portfolio in a rising interest rate environment.  There are methods to mitigate this risk.  Some strategies have already been implemented in portfolios and others will be implemented as conditions warrant. 


In the 2016 Quarter 1 commentary we wrote the following:

The Chinese market and economy have made a lot of headlines over the past year.  The Shanghai Exchange experienced massive volatility in 2015 and the resultant conversation of the financial pundits was that the Chinese economy was headed for a hard landing.  We have never quite understood the general consensus of the financial world towards China.  They have painted a picture of a country laden with debt, lower economic growth prospects, and highly overpriced stock markets (sounds familiar).  But to every one of these arguments there exists fundamental misunderstandings about China.  In the interest of brevity, let’s examine just one…overpriced stock markets.

In the Quarter 1 commentary we addressed the overpriced stock market.  In the Quarter 2 commentary we addressed lower economic growth prospects.  And this quarter we will wrap this up by addressing the misconceptions of China being overextended in debt.  

Wait a minute…there’s actually two sides to a balance sheet?  

During the last decade total debt in China – consisting of corporate, household, government and bank debt – has increased from roughly 150% of China’s Gross Domestic Product (GDP) to over 250% of China’s GDP.  That’s a lot of debt. In fact, when you take into consideration that the denominator in the equation has also increased significantly during that time period the increase in debt gets really big: total debt has gone up 465% in the last decade.  

Our recent experiences in western culture make these numbers very worrisome.  In the US, we have witnessed the danger of an over-leveraged economy: the 2006 housing crisis and the subsequent Great Recession beginning in December 2007.  But to every balance sheet there are two sides: assets (what you own) and liabilities (what you owe).  What is being largely ignored in the case of China is the asset side of the balance sheet.  

Let’s take a look at the household debt burden in China within the context of the real estate market.  In the last few years many pundits have expressed concern of a growing bubble in Chinese home prices.  Home prices have increased roughly 9% – on average – every year for the last 10 years.   In our economy those high increases would be troubling.  But Asian cultures tend to look at savings and debt differently than western culture.  In short, they save more and they go into less debt. A few statistics to consider:

  • Wage increases have averaged roughly 13% per annum for the last 10 years, which outpaces the home price increases.
  • In order to buy a home in China a 20% down payment is required.  That is not a banking standard.  It is a law.  That is if it is your first home.  If you are buying an investment property (second home) 30% is required. 
  • A 2014 study showed that 15% of all real estate purchases were paid with 100% cash.
  • According to a China Household Finance Survey in 2012, average household debt amounted to only 11% of home value; the median household debt was 0%.   
  • The same 2012 survey indicated that if home values fell 50% only 14% of mortgages would be underwater.  

Those stats paint a very different picture than an over-extended, over-leveraged consumer.  And a similar picture could be painted for corporate and government debt: there are assets to support their level of debt.  Even the structure of the debt (state financed in a closed system) makes the debt level more palatable.  While Chinese debt has grown excessively during the last several years it appears to be at manageable levels. 

That is not to say there is no risk here.  In our opinion this increase in debt is going to continue for some time.  China has aspirations for their currency (Yuan) to be used more heavily in international transactions and as a reserve currency.  In order for that to happen there needs to be more volume of Yuan in the market.  In a fiat currency system, money is created and put into circulation through debt.  If China wants more Yuan in circulation then more debt will be required.  Continuing to fuel this debt may put more strain on the Chinese economy.  While we do see long term value in investing in China we will be closely monitoring the situation watching for meaningful economic deterioration. 

As we examine the global landscape, China – and other select Emerging Markets – continue to have the greatest potential for long term growth.  We believe patient investors who endure the volatility often experienced in these markets will see long term gains.  We also see developed markets – such as the US and Europe – struggling to obtain meaningful economic growth.  As central banks and governments make more decisions and businesses and individuals continue to adjust to an economic environment very different than it was a decade ago we believe markets will continue to be volatile.  Throughout these developments we will continue to invest in areas where we see value and the greatest potential for long-term growth.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

2016 Q2 Commentary

Please Brexit at the Next Vote

On June 23rd the United Kingdom voted to leave the EU. Prior to the vote polls indicated the populace would vote to remain in the EU but we were all reminded why polls come out with a margin of error. The outcome of the vote caused a degree of panic across markets as people digested the news.

How much actual damage will occur from the Brexit is yet to be seen. Once a member country has notified the EU of its intent to leave they have two years to negotiate the details of the withdrawal…there is still some time before anything will be technically different. But the preparation for withdrawal will be costly to the UK and companies operating in the UK. Over 50% of the UK’s trade goes to countries in the European Union. New trade agreements will be required with each individual country and then businesses will have to comply with each individual agreement. This will increase costs and uncertainties over the next couple of years.

Longer-term consequences are harder to see. Most economists and other outspoken public officials seem to be of the opinion that this will be bad for the UK and for the EU. In reality, it is impossible to know. Not only could there be unknown negative consequences but there could also be unknown positive consequences. For example, British officials have already begun dialogue with Asian and other emerging countries to negotiate new trade agreements. Those officials will have more opportunity to negotiate agreements beneficial to England as opposed to subordinating their interests to that of the EU. A pivot towards trading more with emerging economies that are less debt laden and more room for economic expansion than EU member nations may prove to be a long term boon to the their economy. Only time and decisions will tell.

Where the greatest risk appears to be in this scenario is any contagion effect the Brexit will have on other nations leaving the EU. There are already political parties in several EU member nations pushing for an EU referendum. If viewpoint begins to steamroll – as it did in the UK – than there could be a lot of political and therefor economic turmoil in the EU. We will maintain a close eye on the situation to see if changes to risk warrant adjustments to portfolio positions.


In our last commentary we wrote the following:

The Chinese market and economy have made a lot of headlines over the past year. The Shanghai Exchange experienced massive volatility in 2015 and the resultant conversation of the financial pundits was that the Chinese economy was headed for a hard landing. We have never quite understood the general consensus of the financial world towards China. They have painted a picture of a country laden with debt, lower economic growth prospects, and highly overpriced stock markets (sounds familiar). But to every one of these arguments there exists fundamental misunderstandings about China. In the interest of brevity, let’s examine just one…overpriced stock markets.

Let’s consider another one of these misunderstandings…lower economic growth prospects.

How Much Slower is Lower?

China has experienced unprecedented economic growth over the last 2 decades. Looking back over the last 20 years the annual Gross Domestic Product growth rate has ranged from 8% to over 14% on an annual basis and never experienced an economic contaction during that period. In terms of size, total GDP has grown from just under $1 trillion in 1996 to over almost $10 trillion today. That’s an average annual growth rate of over 13%.

What many economic and market pundits find alarming is the trend-line of growth. Looking at the below chart you can easily point out a downward shift in annual percentage GDP growth. Growth peaked in 2007 at around 14% and has steadily declined since. It currently sits in the 6.5% to 7% range and the International Monetary Fund estimates growth to be 6.3% in 2016 and 6% in 2017.


There is no arguing with the numbers and facts – Chinese economic growth as a percentage of GDP is slowing – but we find the worry surrounding this situation to be puzzling for a couple reasons. First, answer this….which would you rather have? 12% of $350,000 or 6% of $1,000,000. I don’t know about you but I want to sign up for the 2nd deal…its $18,000 more. Now, add a few zeros to the equation and you are looking at the GDP growth of China. While the economy is experiencing lower growth on a relative basis it’s current total $ growth still out-paces the higher % growth rate of 5-10 years ago.

Secondly, when did a 6% growth rate become a bad thing? Since 1970, the US has experienced greater than 6% GDP growth in one year (1984) and the US Federal reserve is projecting a growth rate of 2.2% for the US in 2016 and slightly less in 2017, which we feel is optimistic. Admittedly, comparing developed US growth to developing China growth is not an apples to apples comparison but it does help put into perspective reasonable expectations. In the slow growth era the global economy is currently in 6% growth is nothing to shake a stick at.

Over the next several years we do expect a slight continued slowing or – at best – a stabilizing of Chinese economic growth but we do not think it warrants as much concern or worry as many people are giving it. As the numbers above show, even with a slower growth rate than it was once accomplishing China is still experiencing substantial growth at a rate unseen in developed economies and higher than most developing economies. With a growing middle class and an economy in the midst of shifting from being export driven to being consumer driven we believe there is plenty of opportunity for prudent active management to identify and take advantage of growth opportunities.


The Brexit vote does cast another shadow over global growth prospects but only time will tell how long a shadow it casts. We are constantly looking out for risks and also looking for pockets of opportunities where we feel the potential return is commensurate with risk. We feel we have identified some areas but also remain cautious as the global economy continues to work through the challenging environment it has created for itself. We will continue to invest in areas where we see value and the greatest potential for long-term growth.

Past performance is not a guarantee of future earnings. Asset allocation does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

A $65,000,000 Deceased Eagle? The Subjective Nature of Value

In 2007, an art dealer/collector by the name of Ileana Sonnabend passed away. Within her rather large and valuable art collection – her net worth was estimated at $1 billion – was a piece titled, Canyon. The artist, Robert Rauschenberg, used a combination of paint, sculpture and a stuffed juvenile bald eagle in constructing the piece. When I say a stuffed bald eagle I’m not talking a stuffed animal you’d buy your kid to snuggle with. This was an actual taxidermied eagle.

In the audit of Sonnabend’s estate tax return the IRS noticed this prized piece of art had been valued at $0.00. While that may seem strange it was with good reason. In 1940 congress passed the Bald and Golden Eagle Protection Act making it illegal to possess, sell, purchase, transport, import or export a bald or golden eagle in any condition…dead or alive. Ms. Sonnabend had been granted permission to retain her ownership of the piece as long as it was on display at a public museum but it was illegal for her estate to sell it.

What’s the worth of something you can’t sell? The valuators of the estate argued it was $0.00. The IRS on the other hand came to a valuation of $65,000,000, which came with a $40,000,000 tax and penalties bill (see here for NY Times article).

Two different groups looked at the same set of facts, the same circumstances and came up with valuations that were $65,000,000 apart. How can that happen? Each side had reasons for their figures but let’s not get lost in details. From a big picture standpoint it happened because valuations are subjective. They require assumptions. They require individual opinions.

Take a dental practice valuation for example. There are a number of subjective elements to a dental practice valuation. If the valuator utilizes a cash flow method they have to make decisions on what to include as add-backs to net cash flow. There’s no standard to that (at least not one I can agree with) and what and how much of what gets added back in is up to debate. And that’s only the beginning. How do you figure replacement value? What about the capitalization rate, which is partly a product of intangibles like location.

You may or may not be familiar enough with valuation lingo to know exactly what I’m talking about but I’m sure you see my point…when you look at a practice valuation you see an opinion derived through a lot subjective decision making. Give two different valuators the same info and you are likely to get two different answers. Add a third and I’m sure we could all guess the result…a different number.

That’s not to say valuations are meaningless. They do have value. But the figures shown should not be viewed as sacrosanct and in a merger or acquisition the value figure should not be solely relied on to drive price. What does matter? The answer is dependent on whether you are the seller or the buyer. Let’s start with the seller.

Have you ever watched the Antique Roadshow or at least seen a clip of the show? Ever noticed what the experts say when they are giving a dollar figure to the person who brought in the 18th century Chinese rhinoceros horn cups (really). In this specific instance they state auction value. At other times they state retail value or insurance value. There’s differences in those definitions but all of them revolve around the same concept – how much money someone will pay the owner to part with the item. For the seller of a dental practice, that’s what matters. How much you can get for the practice.

What a buyer should be looking for is the return on investment. The value of dental practices is almost entirely made up in their cash flows. The assets of the business have little value (secondary market equipment value is much much much much much lower than new purchase cost). The “asset” with the greatest value is goodwill but the value of goodwill is usually derived from the cash flow of the business which brings it back around to cash flow being the predominant driver of value. What a buyer needs to be concerned about is what kind of cash flow they will receive from the practice and what risks exist to the sustainability of that cash flow.

Do not get too attached to valuations. If you are selling a practice, use it to assist you in establishing an asking price. If you are a buyer, use it as a starting point to determine what return on your investment you could expect to receive.


The Value of Process

Whenever I’m in a conversation with someone and my job comes up I’m almost invariably asked if part of what I do is help people budget.  Usually I respond with a zealous, NO!!!  I have no interest in telling people what they should be spending on their hobbies or caffeine consumption.  And the good news is my clients do not want me to tell them. We are on the same page.

What I do encourage, and help, my clients to do is to go through the process of backwards budgeting. This is what I like to call the spend what is leftover strategy. The process begins by establishing your financial goals. Typically the goals revolve around retirement but it can also be larger expenditure items.  For example, I’ve walked clients through this planning to prepare for purchasing real estate for their practice.  Whatever the goal, or goals, the process is the same…define how much it is going to cost and what kind of savings it will take to pay for it.

At the end of the process what you have is a number.  This number now becomes sacrosanct.  As long as the income is coming in that amount of money goes towards the goal (or goals).  Then you look at what you have left over. That’s where your personal budgeting can begin.

I’ve simplified the process for illustration purposes.  There are a lot more layers of complexity to this process, or at least there should be.  Accurately defining and prioritizing your financial goals is a process in and of itself.  Maximizing the saving dollars through tax advantaged planning (business owners can really make some money here) and cost benefit analysis on financial products should also be considered.

But the value is the process itself because you have goals and an in-depth knowledge of what you need to do to accomplish them. The planning you have completed now sets parameters for all your other financial decisions.  Everything else flows through the lens of this process.  How much money can we spend on a home?  What about a vacation?  That renovation project?  Those decisions can now all be run through this plan.

In my experience, when people do not go through this process and these parameters are not established than they are setting themselves up to make poor or – at best – inefficient decisions.  Ever seen someone blow through $600,000 of income per year?  I have.  What about a large inheritance…that too.  In all these cases a plan was never developed.

Granted, those are extreme examples but it does speak to the point that if a plan isn’t made than money will not be allocated as effectively.  If you don’t go through this process you may not blow through all your income but decisions will be made haphazardly.  Saving for retirement or college for children will be done as money is available.  When it comes time to make that business investment the cash needed won’t be there.  You may miss years, and thousands of dollars, of tax advantaged planning.  And then years down the road you have less money or you had to settle for a worse deal than if you would have simply taken the time to plan.

Go through the process.   It is worth the time and will payoff immensely years down the road.

A Ski Resort in Florida

In his book, The Most Important Thing, Howard Marks recounts the fictional tale of a man with an insane business idea: open a ski resort in Miami.  Competition would be sparse, to say the least.  The man invested money in the land, infrastructure and ski lifts.  His first season in business a blizzard hit bringing 12 feet of snow to Miami.   The man made a nice profit.

Was his decision to put this resort in Florida a good decision?  He made a lot of money, right?  Then it must have been a good decision.  Well, actually, no.  Any sane person would conclude this man made a terrible decision but was impossibly lucky.

While the story is fiction and the results are exaggerated this scenario plays out all the time.  People have a tendency to judge decisions based on outcome…a decision resulted in a good outcome so it was a good decision or, a decision resulted in a bad outcome so it was a bad decision.  This type of decision making is commonly called outcome bias.  Outcome bias represents one of the most challenging aspects of finance and investment decision making.  Just because something worked does not mean it was a good decision (like our guy in Florida).  And just because something failed does not mean it was a bad decision.  Outcomes alone do not tell the whole story.

When examining results there can be many unseen factors at play and a lot of times things that seem like good decisions can simply be chalked up to a good dose of luck.  That friend of yours who made a lot of money in real estate and is trying to get you to jump in…maybe they got lucky.  They happened to buy the right property at the right time and was able to sell it for hefty penny.  That does not mean it is a good thing for you to do.

If financial and investments decisions can’t be simply made by looking at outcomes how does one go about making good decisions?  Through quality decision making processes – processes that evaluate the merits of the situation.  Do not rely on the outcomes experienced by friends, family members, co-workers or some guy you read on an Internet blog (irony?).  Go through the process of understanding what is involved.  Understand why those people succeeded or failed.  Understand the risks involved.  Understand the consequences if it fails.  Look into the probability of failure.  Ask questions…lots of them.  Do not just assume things will work out (or won’t work out) because they did for someone else.

How do you personally make financial decisions?  Is there a process in place?  The Florida ski resort is a cautionary tale in decision making.  Don’t just look at results.  Dig a little deeper and go through the process of evaluating the situation.  And be honest with yourself about whether you even have the ability to assess the situation.  Humility goes a long way in decision making.  If you don’t know how to make the decision find someone who does.

The Future Benefit of Roth IRA’s

If you want to an evening of contemplative reading google the phrase traditional vs roth ira.  It seems that every financial institution has information to help investors make the decision on which type of IRA to use.  For those who already have a Traditional IRA there are countless calculators that can help you determine whether you should convert your current IRA to a Roth IRA.  They ask for information such as current tax rate, future tax rate, time till withdrawal and a few other pieces of information to help you make your decision.

These calculations will provide you with dollar and cents answers but the one factor I rarely see people consider is how changing tax laws could impact a Roth IRA.  The real tax benefit of a Roth IRA is received at some future date.  Yes, your dollars are allowed to grow without paying taxes every year for realized gains and income but the greatest benefit (and the differentiating factor from the Traditional IRA) is that no taxes are owed when the money is withdrawn at a future date.  If you are in your 30’s or 40’s that future date could be between 15-35 years away. That’s a long time for things to change. What could change? Let’s look at one example:

At the time I am writing this (March 2015) at least one of the remaining Republican candidates for the Presidency has proposed a tax plan that includes a 15% flat income tax and the implementation of a Value Added Tax (VAT).  As Americans, most of us are not familiar with the VAT tax system.  It was widely implemented in Europe in the 1960’s and is in place in a large portion of the world’s developed economies. To keep the explanation short it is a tax on goods purchased. That may sound like a sales tax but the tax isn’t levied at the point of sale. It is levied at each level of production of the good.  The bottom line…the tax gets baked into the price of the good you are purchasing, which makes that good more expensive to buy.

Bringing this back around to the Roth IRA…if a VAT tax were to get implemented the money you invested in a Roth IRA so you wouldn’t have to pay taxes on withdrawals are now being taxed through increased price of goods.  In this instance the tax benefit of a Roth IRA is reduced.

This is example of what could happen.  I am not saying it will but it could. And there are other possibilities of things that could happen.  A lot of strong proponents of Roth IRA’s use the argument that tax rates are going up (sometimes with the supporting point that taxes only go up, never down…go look at historical tax rates in the US and let me know how well that argument stands).  If taxes are going up because the government needs more revenue than how do we know those taxes won’t get levied against Roth IRA’s?  Don’t think the government will do that?  Once again, look to history to see what our government will or won’t do when it comes to tax law…I think you will be surprised.

Is this to say Roth IRA’s are bad and should never be used? No. But the question I would encourage you to consider is why would you give up a tax benefit you can get today (deduction for a Traditional IRA contribution) in exchange for one you might get in the future (tax free withdrawals from a Roth IRA)? The tax savings you receive from Traditional IRA contributions are real dollars.  Dollars that can be used elsewhere…reducing a mortgage balance, saving for college, etc.  Is the promise of a future benefit worth giving those dollars up? It is a question worth considering.