Wealth and Income Inequality

 There is generally a high degree of correlation between wealth and income. The reason is obvious - for the most part, financial assets generate income in the form of interest, dividends, and capital appreciation. The more assets owned by an individual, the higher the level of income generation. There are of course some exceptions to this close relationship between wealth and income. An investor sitting on a pile of gold receives zero income from his precious metal holdings, but could have a significant net worth. Another classic example would be the occasional NBA superstar who earns tens of millions of dollars per year for a finite number of years. However, due to a profligate lifestyle, income tax obligations, and incompetent, if not outright unscrupulous, agents and managers, finds himself in bankruptcy court when his playing career comes to an end. For the purposes of this blog, I'll be making the assumption that high wealth and high income are interchangeable. My goal is to outline a thesis detailing how economic disparity is viewed by Americans and then explain why the discrepancy has widened so much since the Great Financial Crisis (2008-2009).

Like practically every other political issue these days, conservatives and liberals typically hold dramatically different viewpoints on income inequality. Progressives tend to claim that Americans with high incomes don't pay their "fair share" of taxes and promote extensive redistribution (income) efforts. I've never heard or read what redistribution advocates define as "fair share." Many conservatives, including myself, offer a counter-argument pointing out in no other country do the rich bear a greater share of the income tax burden than they do in the United States. In terms of federal income taxes, the top 1% of taxpayers in the U.S. pay 40% of taxes paid, the bottom 20% have negative tax rates. Over 40% of households pay no federal income tax. When the data are adjusted to account for all government programs that transfer income, the U.S. is shown to have an income distribution that aligns closely with its peers. It seems both unfair and illogical to demonize and target the taxpayers who tend to be the smartest, hardest working, and most productive participants in the economy. All that said, I take the position it may be wise to tweak the tax code and various government programs at the expense of the wealthy and to the benefit of low and middle income Americans. History tells us that a society needs a release valve when a significant portion of the population is falling further and further behind the well-to-do. Otherwise, social unrest and violence is all but inevitable.

As with many of my previous financial blogs, I intend to place the blame for growing wealth/income inequality squarely on the monetary policies of the Federal Reserve Bank and the fiscal negligence of the United States Congress. Zero or near-zero interest rates in the wake of the 2008 financial crisis (2008-2015) and the Covid-19 pandemic (2020-2022) are coming home to roost in a most distressing manner. ZIRP (zero interest rate policy) that was aimed at stimulating economic activity ended up serving the needs of big government, big business, and owners of financial assets, while ordinary savers received almost no return on their savings for more than a decade. The largest borrower in the world is the U.S. government. The Treasury reaps the benefit of borrowing at a reduced cost when interest rates are held down. Large corporations are beneficiaries of Fed largesse when they can borrow money cheaply to buy back their own shares in the equity markets. By artificially increasing the earnings-per-share, they raise the price of their stock. Because many top executives have compensation packages linked to their companies' share price, this maneuver rewards these executives. Wealthy individual investors are especially well positioned to benefit from "accommodative" monetary policy. They borrow funds at extremely low interest rates and proceed to arbitrage high returns from pumped-up equity markets against a low cost of borrowing.

It's abundantly clear that monetary policy can channel financial benefits to some members of the population at the expense of others. While interest rate manipulations by monetary policymakers offer up a speculator's paradise for those who can grab quick profits by trading derivatives and currencies, these manipulations make life considerably more challenging for people who must function in the real economy. In her 2021 book, "The Engine of Inequality: The Fed and the Future of Wealth in America," financial consultant Karen Petrou explains: "Ultra-low rates fundamentally eviscerate the ability of all but the wealthy to a gain an economic toehold; instead, they lead investors to drive up equity and other prices to achieve return-on-investment objectives, but average Americans hold little if any, stock or investment instruments. Instead, they save what they can in bank accounts. The rates on these have been so low for so long that these thrifty, prudent households have in fact set themselves back with every dollar they save."

The main impetus for the aggressive post-GFC expansion of the country's money supply was to spur faster economic growth. In addition to keeping rates at effectively zero, the Fed utilized QE to purchase government debt securities. To the surprise of many economists and policy wonks, the economy remained sluggish. Even more surprising, inflation all but disappeared for the second decade of the 21st century. Normally inflation results when the money supply dramatically increases. Where did inflation go? The answer is that inflation from 2010 - 2020 was concentrated in asset values, primarily equities and real estate. Inflation in goods and services did not appear until the government mailed stimulus checks to Americans during the Covid-19 pandemic. To finance this massive outlay along with all the other Covid-19 relief programs for businesses, Uncle Sam had to issue a boatload of debt securities. A good portion of this new debt was purchased by the Federal Reserve Bank. The burden of paying this debt will fall on future generations. Government debt securities are claims on future tax revenues derived from wealth yet to be created and incomes yet to be earned.

The structure of our economy has fundamentally changed over the second half of the 20th century and first quarter of the 21st century. We are no longer a productive economy that makes products of substance. The United States is now a financialized economy, where the financial sector and its priorities have become increasingly dominant in all aspects of the economy. The U.S. financial sector grew from 10% of GDP in 1950 to 22% by 2020. In 1950, manufacturing had 40% of all profits and 29% of the nation's jobs; today, financial enterprises have 40% of the nation's profits with 5% of the jobs. The real economy and financial markets have reached the point where they are practically totally detached and fundamentally at odds. While Main Street has lagged or even retreated, Wall Street has thrived. Growth rates of the economy since 2008 do not in any way support the valuations of the stock market.

Policies introduced by the Fed and other central planners have enriched elites at the expense of poor and middle-class Americans. No where in the Constitution does it say that money shall be regulated in such a way that some groups benefit more than others in accordance with decisions made by the nation's central bank. It is blatantly inconsistent with founding principles to allow monetary authorities to deliberately debase the dollar in order to achieve what they construe to be "price stability." Perhaps the Fed should simply serve as the lender of last resort and allow the free market to determine levels of interest rates and the country's money supply. As evidenced by multiple surveys over the past 15 years, faith in our institutions and capitalism is waning. When citizens believe the system is "rigged" to reward those who are already at the top in terms of wealth and income, this belief feeds an attitude of resentment and cynicism. As we have recently evidenced, an environment of this nature is a rich breeding ground for political populism.

Is Buy and Hold Dead?

For the context of this blog posting, the term "buy-and-hold" specifically refers to an investment strategy whereby an investor buys equity securities with the intent to hold them long-term with the goal of realizing price appreciation. This is strategy endorsed and often utilized by historical investment icons such as Jack Bogle, John Templeton, Peter Lynch, and of course, the legendary Warren Buffett. Although, in the past few years, it appears Mr. Buffett has liquidated and converted to cash many of his holdings in various companies. The majority of professional participants in the investment world now believe buy-and-hold is basically dead and gone. I don't believe buy-and-hold is dead and gone, but it's definitely on life support.

One reason buy-and-hold has fallen out of favor is that the strategy implies the risk of assets is always justified by the reward. The idea that every year is a good year to own equities is patently false. The risk of buying and holding securities is not justified by the reward under certain conditions. Another problem with buy-and-hold is the implication that prices don't matter because the strategy requires you to buy-and-hold at all times regardless of price or valuation. Is there any other buying decision in your life where price doesn't matter? The answer to that question is glaringly obvious. Besides completely ignoring the essential investment concept of managing risk, buy-and-hold requires little intelligence, skill, or serious effort. Combined with the ongoing trend of passive investing, this is a recipe for disaster.

There are additional reasons why a buy-and-hold strategy, while not complete nonsense and outdated, is a risky endeavor these days. It totally misses the dynamic evolution of the world - everything changes throughout time and the speed of change is ever-increasing. The number of variables at play also is increasing at a geometric rate. Another risk is the reduced lifespan of a business, even originally successful businesses. The lifespan of large, publicly traded companies has significantly decreased over time, with some studies indicating a current average lifespan of around 15 years or less. More stocks have vanished or gone to zero than have survived to this day. One of the chief reasons buy-and-hold isn't king anymore is due to the new, more extreme conditions in the market. Although currently in hibernation, volatility and the Bear have not gone extinct. Through greed and lack of attention, our markets are sometimes built on inflated bubbles. I can make the argument that is presently the case. Furthermore, while timing the market to perfection is improbable, if not impossible, wise investors tend to reduce their exposure to stocks when the market is expensive relative to the fundamentals, and keep their exposure down - if need be, for years - until the market becomes much cheaper. It then involves increasing exposure, and keeping it high, again for years, if necessary.

As mentioned, the market is more dynamic than ever. Investors will miss out on gains from shorter term movements if they rely exclusively on buy-and-hold and do not hold capital for shorter term investments. Buy-and-hold is a purely offensive investment strategy that ignores the defensive half of the investment equation. At times it makes sense to take a short position in a stock. Warren Buffett was mentioned earlier. Probably no other investor has been more closely associated with buy-and-hold than Mr. Buffett. His baby, Berkshire Hathaway, has recently sold a substantial amount of stocks and is presently sitting on a record $325 billion cash pile as a result. Old Warren believes equities are severely overvalued and a market crash is possible. He is wisely waiting for bargain basement opportunities. This is not the behavior of a true blue buy-and-holder.

  

Optimum Asset Allocation Model?

 If not an outright trick question, the title of this blog is misleading. The optimum asset allocation can only be determined in retrospect, for nobody can read the future. At least not accurately. When establishing an asset allocation model for an investor, one size does not fit all. Multiple variables come into play when establishing an investor's customized asset allocation parameters. Besides personal preference and financial goals, the next most important component would be somebody's level of risk tolerance. A person who can't psychologically deal with a stock market correction (down 10%) or a Bear Market (down 20%) should have minimal portfolio exposure to equities. Other important factors to take into consideration would be an investor's age, health, and level of current and expected interest rates.

Before looking at different allocation models, let's delineate the major asset classes. These asset classes would be as follows: 1.) Cash and Cash Equivalents (includes Treasury bills); 2.) Equities (stocks); 3.) Fixed Income (bonds); 4.) Real Estate; 5.) Precious Metals (gold and silver); 6.) Commodities; 7.) Foreign Currencies; 8.) Cryptocurrencies; 9.) Collectibles. It goes without saying many of these categories could be further divided into sub-classes. For example, Fixed Income could be broken down into U.S. Treasuries, corporate bonds, and municipal bonds. Real Estate could be further divided into residential, commercial, and agricultural real estate. For our purposes, we'll stick with the general classes in order to avoid getting stuck in the mire of excessive details.

Historically, 60% equities and 40% bonds has been the most common allocation recommended by financial advisors. This has been considered a balanced portfolio and has been the standard for decades. Quoting songwriter and crooner, Bob Dylan - "And you better start swimmin', Or you'll sink like a stone, For the times they are a-changin'." There has been an evolution away from 60/40 and toward other investment allocation options. The primary reasons away from 60/40 would be high equity valuations, Federal Reserve Bank monetary policies, increased risks in bond funds, and low prices in the commodities' markets. Many experts are now saying that a well-diversified portfolio must include more asset classes than just stocks and bonds. Besides those asset classes itemized in the previous paragraph - private equity, venture capital, and private credit are now often incorporated in the modern investment portfolio.

There once was an old rule of thumb that utilized the investor's age to determine the stock/bond allocation in a portfolio. For a thirty-year-old, the recommendation was to hold 30% in bonds and 70% in equities. For a fifty-year-old, the recommendation was to hold 50% in both stocks and bonds. Thus, for a seventy-year-old, the recommended allocation was 70% in bonds and 30% in equities. In our topsy-turvy world, older investors these days often turn this approach on its head and flip-flop to 70% equities and 30% bonds. The percentage Baby Boomers are allocating to stocks is at an all-time high. These folks are ill-prepared to weather a 30%-50% down market.

I've always been partial to the 30/30/30/10 allocation model allocated as follows: 1.) 30% - stocks; 2.) 30% - bonds; 3.) 30% - real estate; 4.) 10% cash. The double-digit percentage in cash would be applicable when short-term interest rates are depressed as they were during the Covid-19 pandemic. Otherwise, I would take cash to 5% and increase equities to 35%. In an environment where the continued debasement of our currency is a distinct possibility, I would be comfortable with the following allocation: 1.) Equities - 40%; 2.) Fixed Income - 20%; 3.) Real Estate - 25%; 4.) Gold and Silver - 8%; 5.) Bitcoin - 2%; 6.) Cash - 5%. Equities, real estate, and precious metals total 75% in this scenario and offer some protection against inflation. If major inflation and loss of purchasing power are a strong possibility, the 12/20/80 asset allocation rule may appeal to some. In this scenario, an individual holds 12 month's worth of expenses in safe, liquid funds. Then, the remainder of his assets are divided between equities (80%) and gold (20%).

For those investors with a contrarian bent and a morbid fascination of market crashes, I suggest extending consideration to what I'll refer to as a "Black Swan Portfolio." In the context of finance, a black swan event is used to describe a rare, random event that nobody sees coming that poses a significant risk to the stock market and economy. Some historical examples would include 9/11, Great Financial Crisis (2008), and the Covid-19 pandemic (2020). The term is closely associated with the trader and author, Nassim Taleb, and founder of the hedge fund Universa, Mark Spitznagel. The "Black Swan Portfolio" is quite basic in its application and has been widely successful in the rare times it has been implemented. The first component of the strategy is to go long the S&P 500 Index for 97% of your investment portfolio. Using the SPDR S&P 500 ETF Trust (ticker symbol SPY) is an instrument that can be used. Next, with the remaining 3% of your portfolio, buy deep out-of-the-money put options on SPY (60-90 day expirations), and do this on a regular basis. By doing this you are effectively shorting the market, tail-risk hedging, and possibly realizing a windfall if a Black Swan event materializes. Be prepared  to suffer small losses for literally years before the money spent on the constant purchase of put options pays off. As mentioned, the Covid-19 pandemic was a Black Swan event and the market tanked in March 2020. The aforementioned Mark Spitznagel's hedge fund (Universa) made a return of 3,612% for that month alone, and over 4,000% for the year 2020. I have to assume Universa's investors were elated to benefit from a 40 bagger in 2020.