Summer 2019 Newsletter

An expanding economy, falling bond yields, and a Fed that is poised to cut interest rates have pushed the Dow, NASDAQ, and S&P 500 Index to new highs, countering headwinds from trade and a slowing global economy. Year-to-date, returns have been impressive.

Yet, it’s not all sunshine and roses. Small caps are up but have lagged the large-cap indexes, creating anxieties in some corners that today’s rally lacks a broad base and may not be sustainable. Still, let’s not discount the importance of the new highs in key indexes.

Headwinds and risks never completely abate. When the perception arises that hurdles no longer exist, perfection gets priced into stocks and small disappointments can lead to significant pullbacks. We saw that situation arise in early 2018.

U.S. markets

1. Powell’s about-face on interest rates

• The Fed’s 180-degree pivot, which began in January, is just about complete.
  • Gone is talk of “gradual rate hikes.”
• Fed Chief Powell’s testimony last week before two Congressional committees green-lighted an expected rate cut at the July 30–31 meeting.
  • Fed funds futures put odds of a 25bp cut in rates at 66% and place a 50bp cut at 34% (as of July 17).
  • Credit dovish testimony from Powell last week for talk of a more aggressive stance.
  • Is 50bp at the July meeting too aggressive? Seven of 17 Fed officials see a total reduction of 50bp by year end, according to the Fed’s dot plot. No one projected more than 50bp.
• Powell incessantly harped on trade uncertainties and the possible impact on business confidence and capex outlays.
  • No longer does the Fed appear to be data-dependent. Instead, its emphasis on uncertainty appears to be paving the way for an easier monetary policy.
• The big unknown: Will falling business confidence significantly impact capital spending, which in turn slows hiring and dampens consumer confidence and consumer spending?
  • There isn’t a modern historical precedent to model the impact of a trade war on the economy.
• Low inflation is giving Powell and the Fed the cover to ease inflation.
• Inflation has remained surprisingly low for an economy that sports a jobless rate under 4%.
  • The Phillips curve, which suggests there is a tradeoff between inflation and unemployment, is broken.
  • Using either the core CPI or the core PCE Price Index, inflation has hovered near or below 2% since 2012.
• Using the core CPI, the Fed has achieved its target of 2% inflation.
• But the Fed’s preferred inflation gauge is the PCE Price Index, not the CPI.
  • The core PCE has averaged 1.64% since 2012 and has rarely exceeded 2%.

Figure 1: Core Inflation-Percent Change vs. 1 Year Ago

Will inflation permanently hold at lower levels?

• The core PCE has slowed over four distinct periods since 2012.
• Might we accelerate again to near 2%, only to fall back?

Inflation and Fed intentions

Powell suggested low inflation is a rising concern at the Fed in this remark during the Q&A session with senators.

“You don’t want to get behind the curve and let inflation drop well below 2%. Because what happens is that you get into this unhealthy dynamic potentially where lower expected inflation gets baked into interest rates, which means lower interest rates, which means less room for the central bank to react and that becomes a self-reinforcing thing.

We’ve seen it in Japan and we’re now seeing it in Europe. That’s why we think it is so important that we defend our 2% inflation goal here in the U.S.”

• A subtle but significant shift—Powell is no longer talking “transitory” as he was just a couple of months ago.

Is the Fed succumbing to White House pressure to cut rates?

• Publicly, Powell has asserted the Fed’s independence. How meetings play out in private may be another matter.
• Economic growth has moderated, and the bond market has gotten ahead of the Fed, but growth has yet to falter.
• Interest rates are already low, but the Fed is hoping to spark a rise in business confidence by tapping the monetary gas pedal.
• Fed officials must anticipate trends, as monetary policy works with a lag.

2. Monetary ammunition

• The fed funds rate is 2.25%–2.50%.
• Table 1 highlights the rate cut cycles during prior recessions.
• While I’ve included recessions going back to 1957 (excluding the short 1980 recession), let’s focus on the last three recessions.

• Rates were much higher heading into the 1990, 2001, 2008 downturns.
• There’s not much room to cut in the event growth falters.
• The Fed lacks the conventional firepower to deal with an economic downturn.

3. The tale of two economies

• Manufacturing is soft, while the service sector/consumer spending is holding up.
• We see it in the ISM Manufacturing Index, the regional Fed manufacturing surveys, and industrial production (though June’s manufacturing output surpassed expectations).
• Services and consumer spending have proved to be more resilient, as they are less dependent on the global economy.
• Retails sales have posted modest to strong gains in four of the last five months.
• Three-month annualized retail sales minus autos and gas stations have been strong—see Figure 2 below.

Figure 2: Consumers Ignore Trade Headlines

• Consumers don’t seem to be paying much attention to trade headlines.

Other indicators

• Job growth has moderated versus a year ago, but businesses continue to hire.
  • Average monthly increase in non-farm payrolls has been a respectable 172,000 in the first half of the year versus 235,000 a year ago.
• A low level of jobless claims suggests employers are reluctant to lose workers amid an expanding economy.
• The Fed’s most recent Beige Book, which summarized the anecdotal activity between mid-May and early July, noted, “The outlook generally was positive for the coming months, with expectations of continued modest growth, despite widespread concerns about the possible negative impact of trade-related uncertainty.”

4. A peek ahead

I. GDP expected to slow in Q2

• The Atlanta Fed’s GDPNow model suggests Q2 expanded at a 1.6% annualized pace, down from 3.1% in Q1.
  • One-time factors overstated Q1 strength.
• Quarterly numbers can be lumpy. Averaging the periods will provide a more reliable take on economic growth.

Figure 3: Lumbering Ahead

• Consumer spending is projected to rise a strong 4.2% in Q2, offset by sluggish manufacturing and business spending.
  • It’s a big rebound from 0.9% in Q1.
• The soft patch in 2019 has not been as pronounced as the slowdown in 2015–16, according to most economic reports.

II. All eyes on earnings

• The pattern we’ve seen through much of the expansion is reasserting itself.
  • Analysts reduce estimates amid conservative guidance and companies top expectations.
  • Today’s culprits—the uptick in the dollar, weaker margins, and the global slowdown.
  • It’s early but 80% of firms have beaten on the bottom line.
  • Until a recession emerges, the pattern seems likely to continue.

^{Source: Charles Sherry, MSc, July 19, 2019}

If you believe the hype, families these days have their kids applying to 10 or more schools, and acceptance rates are at record lows. What’s going on? Lynn O’Shaughnessy, creator of the Savvy College Planning Program, explains what a sensible college application process can look like for 2019.

Step 1: Relax! Most schools accept the majority of applicants

Every year we have media stories declaring, “Oh my gosh, the acceptance rate at Harvard has dropped. The acceptance rates of Stanford and Yale are down.” What these dispatches fail to tell you is that this is just a teeny tiny part of college admissions. What I wish the media would add when they shout about Harvard accepting less than 5% of applicants is, “You know, most kids get into their first-choice school.”

Every year UCLA does a survey of hundreds of thousands of college freshman, and every year the survey results show that about 75% of kids get into their first-choice school. When you think about it, there are 2.2 million traditional students who start in college every year. The number of kids who apply to schools like Yale, for instance, is something like 36,000. This is a teeny tiny percentage of college admissions and yet the media is focused on these few schools, and that just makes everybody panicky.

Most kids aren’t applying to 17 schools, no matter what the newspapers are saying. Roughly a third of students apply to seven or more schools. That means most kids aren’t even doing that many.

The number of colleges a student applies to should be based on what kind of schools are on a college list. If you are looking for schools that want you, that’s one thing, but if all seven are Duke, Rice, Harvard, Stanford, and other Ivies, then it is crazy to apply to that few. At these elite schools there is no admission guarantee unless you have a hook—you’re the child of a billionaire who can donate millions of dollars to a school, you’re a legacy, or you’re a recruited athlete. Then you have a better shot. No one should be applying strictly to elite schools.

Building craziness

This fixation with the most highly ranked schools is more of a problem for high-income students and their parents. These schools are status symbols. And beyond the bragging rights, families don’t know about the different types of schools out there. They recognize only the names of their own state schools and brand-name research universities.

Low- and middle-income families are generally not even thinking about private schools, elite or not. They tend to go to community colleges or nearby state schools.

Part of the reason we see so much more craziness now is that more kids are going to college. When I went to college, maybe 15%-18% of the teenagers my age were going to college.

And there is a perception that there are only a few schools worth going to. Some people feel, “We want our kids to have the best,” and they have to go to these so-called golden ticket schools. Parents feel more desperate as they see headlines every year that say it’s harder and harder to gain admission. So they feel they have to apply to more and more of them. It just feeds on itself.

Step 2: Find colleges with academic profiles that fit your student

College advisors can help their clients’ kids put together a good college list that considers how they would fit in at a school and where they are likely to be accepted. You can look at test scores, GPAs, and the typical freshman class of each specific school. These kinds of statistics are readily available on College Board, CollegeData, the federal College Navigator, and other places.

And definitely look at the school’s acceptance rate. You could have a perfect test score and grade point average aiming for Princeton, but there’s still almost no chance you’re going to get in.

But that’s just an outlier. Most schools, as I said, accept the majority of their applicants. You can look at a school’s acceptance rate and where a child fits in terms of her GPA and test scores.

You can also look at what other criteria a particular school is interested in by going to Collegedata.com. You type in the name of any school and then click on the “Admissions” tab. You will see a box that has 19 admission factors listed and an “x” that indicates whether the school considers each one “very important,” “important,” “considered,” or “not considered.” Pay attention to that.

Oftentimes schools will say they consider “demonstrated interest” which means they want to know that the student is really interested in their school in particular—and not just applying for the sake of applying to a bunch of schools.

The rise in numbers of applications has made more schools consider demonstrated interest. One reason for the growing applications is the Common Application, which roughly 600 schools now use. With the Common Application, you fill out the online document once and you can send it to as many schools as you want. Each school can ask for answers to a few supplemental questions like, “Why are you interested in this school?” Or they may have a specific essay question. But once you’ve filled out the main application, it’s easy for kids to just shoot it off to a lot of colleges.

Make sure to figure out the cost

One of the most important things advisors can do is use net price calculators. Every school, by federal mandate, has to have a net price calculator on its site. Using the tool, you’ll be able to see what a college says you will have to pay after any merit scholarships are deducted. That’s why it’s called a “net” price calculator. That’s super important.

Step 3: Consider early decision

If a child is focused on one particular school and the parents are prepared to pay the cost of going there, applying “early decision” or “early action” is an option. This growing trend in the college application space favors wealthy students, and it really does give you an advantage in the application process. Not every school has early decision, but a lot of private schools do.

When students get into a college via early decision, they agree to attend no matter what. (With early action, you’re not required to go to the school even if you are accepted.) The school could stiff a student and offer no money (scholarships and grants), but the teenager is still supposed to attend. That’s why it’s considered a benefit to high-income students whose parents can pay no matter what the school costs. Other families can’t take that risk.

Because of the promise to attend, whether to apply early decision can depend on whether or not the school has good financial aid. If you have demonstrated need, most elite schools have excellent financial aid. If you apply early decision and get in, you’re likely to get some aid. If you don’t need it, and you apply and get in, you are obligated to pay full price.

Of course, it is kind of based on the honor system that you will definitely go to this school if you get in. That’s what schools are counting on. They like to lock in a good portion of their freshman class early decision because then they don’t have to worry about all those kids applying to 20 schools and leaving the school up in the air as to where they stand.

See what kind of edge it gives you

If you want statistics on acceptance rates for early decision/early action versus regular decision, go to College Transitions.com. There are many admissions statistics on the site. You can see how much of a crazy advantage you get with early decision. For instance, for students who applied early decision to American University, the acceptance rate is 84.5%, and for students who applied regular decision the acceptance rate was 26.6%. That is biggest advantage that I’ve seen.

Keep in mind, however, that American University doesn’t have great aid. So you would be really risking it if you applied early decision to this school. You’d probably have to pay the full price.

Here’s another example: Dartmouth College’s early decision acceptance rate now is 28% versus 8.5% for regular decision. If you apply there and you need aid, they give really good aid. To me that’s not as much of a risk if you’re looking for financial aid, since the school is on record as giving a lot of aid to students who demonstrate need.

As I mentioned, with early action, you’re not required to go to the school even if you are accepted. Yet amazingly the early action acceptance rate is still often higher than regular decision even though you’re not required to attend that school.

I’m looking at Fordham University, which by the way has horrible financial aid, and I see that its regular decision rate is 42.5%, but early action is 50%. So it’s a little boost even though you’re not taking any kind of risk.

Step 4: Choose a good mix of schools

Advisors and families who are building a college list need to choose a good mix of schools. A list could contain public universities (both in-state and out-of-state) and private colleges of various selectivity.

Parents should compare their teenager’s academic profile to that of the latest freshmen class at a college and figure out whether they would qualify for need-based aid or merit scholarships. Again, keep in mind that most schools accept the majority of the students who apply. It’s not that hard to get into college, unless you have restricted yourself to a list of only the elite schools that reject almost everyone, which is just setting yourself up for disaster.

^{Source: Lynn O’Shaughnessy, Apr 25, 2019}

When Social Security was first instituted in 1935, most women did not work. So, in 1939, as part of a sweeping series of amendments, the system made spousal benefits available to any “wife” who either had not earned a benefit or whose benefit was less than half of her husband’s. In 1965 these benefits were made available to any “divorced wife” who had been married at least 20 years. At some point in Social Security’s chronology the word “wife” was swapped for “spouse” and the 20-year marriage requirement for divorced spouses was reduced to 10 years.

Divorce was rare back in those days, but lucky for today’s baby boomers, who have brought the notion of multiple marriages to a whole new level, wives—and husbands—can receive benefits based on a former spouse’s work record as long as certain conditions are met. The rules are not that complicated, but sometimes it can be hard to keep them all straight, especially if there have been several marriages and divorces or if an ex-spouse has died.

Many people are not aware that they can get Social Security benefits based on a former spouse’s record.

In order to qualify for a divorced-spouse benefit a person must:

• Be finally divorced from the worker on whose record benefits are being claimed
• Have been married over 10 years
• Be currently unmarried
• Be at least age 62
• Not be entitled to a higher benefit on his or her own work record [Note: this rule does not apply if born before January 2, 1954 and eligible to file a restricted application.]

Here are eight facts about divorced benefits with examples.

1. Ex-spouse must be at least 62

The worker on whose record the benefit is being claimed must be at least age 62. If the divorce occurred more than two years prior, the worker does not need to have filed for his or her own retirement benefit.

• Example: Michael and Maria were married over 10 years. They have been divorced over two years. Both are age 62. Maria has not remarried. Maria is eligible for a divorced-spouse benefit based on Michael’s work record, regardless of whether or not Michael has filed for his benefit.

2. 50% of primary amount

If the divorced-spouse benefit is claimed at full retirement age or later, it will be 50% of the worker’s primary insurance amount (PIA).

• Example: Jim and Judy are divorced. Jim’s PIA is $2,600. Judy does not qualify for a benefit on her own record. Judy files for her divorced-spouse benefit at age 66. She will receive 50% of Jim’s PIA, or $1,300, as her divorced-spouse benefit.

3. Your own benefit comes first

If the divorced person also qualifies for a benefit on her own work record, she will be paid her own benefit first. If her PIA is less than half of his PIA, she will receive that difference in addition to her own benefit.

• Example: Tom and Trudy are divorced after more than 10 years of marriage. Tom’s PIA is $2,600. Trudy’s PIA is $800. Trudy files at her FRA. She will receive her own benefit of $800 plus the difference between her PIA and one-half of Tom’s PIA ($2,600 ÷ 2 = $1,300 – $800 = $500) for a total benefit of $1,300 ($800 + $500). If Trudy had claimed prior to FRA, both her own benefit and the spousal add-on would be reduced for early claiming.

4. Restricted application

A divorced person who was born before January 2, 1954, who has not previously filed for benefits can file a restricted application for the divorced-spouse benefit at FRA and let their own benefit build delayed credits to age 70. The other spouse can do the same: two ex-spouses can each file on the other’s record at the same time (providing it’s been at least two years since the divorce).

• Example: Mike and Mary are divorced. Mike’s PIA is $2,800. Mary’s PIA is $2,200. Mike’s birthdate is 10/1/53. Mary’s birthdate is 12/15/53. In October of 2019, when Mike turns 66 (FRA) he can file a restricted application for his divorced-spouse benefit and receive half of Mary’s PIA ($1,100) until he turns 70. At that time he can switch to his maximum retirement benefit of $3,696 ($2,800 x 1.32). When Mary turns FRA she can do the same. In December of 2019, when Mary turns 66 (FRA), she can file a restricted application for her divorced spouse benefit and receive half of Mike’s PIA ($1,400) until she turns 70. At that time she switches to her maximum retirement benefit of $2,904 ($2,200 x 1.32).

5. Divorced twice

A person who has been divorced twice can choose the higher of the two divorced-spouse benefits, as long as each marriage lasted at least 10 years and the applicant is currently unmarried. But remember…if she also qualifies for a benefit on her own work record she must take that benefit first (unless grandfathered for restricted application by being born before 1954). And…if she has been divorced less than two years the ex must have filed for his benefit.

• Example: Susan was married to Sam for 20 years. She was married to Steve for 12 years. Susan is now single and it has been more than two years since her divorce from Steve. Sam’s PIA is $2,600. Steve’s PIA is $2,400. Susan does not qualify for a benefit on her own record. She is FRA. When she files, she can choose to receive half of Sam’s PIA since it is higher than Steve’s.

6. Ex-spouse is deceased

If an ex-spouse is deceased, a divorced person can receive a divorced-spouse survivor benefit based on the ex-spouse’s record, providing the applicant is currently unmarried or remarried after age 60.

• Example: Elaine is divorced after 11 years of marriage. She was born before Jan. 2, 1954. When she turned 66 she filed a restricted application for her divorced-spouse benefit and received 50% of her ex-spouse’s PIA. One year later her ex-spouse died. She switched to the survivor benefit equal to 100% of her ex-spouse’s PIA.

7. Government pension offset

If the person applying for the divorced-spouse benefit worked in a non-Social Security-covered job, the divorced-spouse benefit will be reduced by two-thirds of the amount of her pension under the Government Pension Offset. This will likely reduce it to zero.

• Example: Greta worked as a teacher in Texas, where she did not pay into Social Security. She is currently receiving a pension of $3,000 per month. She is divorced from George, to whom she was married more than 10 years. George’s PIA is $2,800. Greta’s divorced-spouse benefit of $1,400 would be reduced by $2,000 (2/3 of $3,000), which reduces the benefit to zero. If George dies, Greta will become eligible for a divorced-spouse survivor benefit. After the GPO reduction she will receive $800 ($2,800 – $2,000 = $800).

8. Married, divorced, remarried—and divorced again

If a couple has married, divorced, remarried, and divorced again, the two marriages can be added together (including the time in between) for the purpose of determining the 10 years, providing the remarriage occurred before the end of the calendar year following the divorce.

• Example: Peter and Paula were married from June 2001 to September 2008 (7 years). They remarried in December 2009 and divorced in November 2012 (3 years). They meet the 10-year requirement because the remarriage took place before the end of the calendar year following the first divorce.

But wait, there is more…

Here are some additional facts to keep in mind:

• The ex-spouse’s marital status is not relevant for a divorced person claiming benefits off an ex-spouse’s record. If the ex-spouse has remarried, both the divorced spouse and the current spouse may receive spousal benefits off the ex’s record (or survivor benefits if he dies).

• When filing for divorced-spouse benefits, the applicant will need to provide a copy of the divorce decree showing the dates of the marriage and divorce. If you don’t have your divorce decree, you can get it from VitalChek.

• It is helpful, but not essential, to provide SSA with the ex-spouse’s Social Security number. This can be found on an old joint tax return. If the ex-spouse’s Social Security number is not available, the worker can access the ex-spouse’s records if given sufficient identifying information (full name, birth date, address).

• It may be difficult to estimate the divorced-spouse benefit until you actually apply for the benefit. SSA usually will not give out this information due to privacy issues. If the divorced-spouse doesn’t have the ex-spouse’s Social Security statement and doesn’t feel comfortable asking for it, you may have to ballpark the estimate. If the ex-spouse was a maximum earner you can safely estimate the PIA to be about $2,800. Otherwise use $2,000 as a broad ballpark estimate.

• Like spousal benefits, divorced-spouse benefits are based on the worker’s PIA. The age at which the worker claimed his benefit is not relevant. That is, the divorced-spouse benefit will be the same regardless of whether the worker’s own benefit is reduced for early claiming or includes delayed credits for claiming after FRA. Also, like spousal benefits, if the worker is subject to the Windfall Elimination Provision because he is receiving a pension from a job not covered by Social Security, the divorced-spouse benefit will be based on the WEP-adjusted PIA.

• If a person receiving divorced-spouse benefits remarries, the person must notify SSA and the divorced-spouse benefits will stop. The exception is if the new spouse is also receiving divorced-spouse or survivor benefits, in which case both benefits may continue.

• Remember the rule on remarriage: If the ex-spouse is still alive, remarriage at any age will stop entitlement to divorced-spouse benefits. If the ex-spouse is deceased, divorced-spouse survivor benefits may be paid if remarriage took place after age 60. If the remarriage took place before age 60, no divorced-spouse survivor benefits may be paid unless that marriage ends.

^{Source: Elaine Floyd, CFP®, May 23, 2019}