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Posts from the ‘Investing & Savings’ Category

15
Jun

Turmoil and the Bear Market

Where we go from here is unknown. There have been many times the stock market and the economy have recovered from worse. The following is intended to be a general discussion. How to proceed will depend on each person’s circumstances (it depends). There are numerous technical issues not included in this discussion.

During the intensely volatile first 100 trading days of 2022, the Stocks of companies in the S&P 500 index delivered their worst performance since 1970 .1 The S&P 500 continued to tumble, and the benchmark index descended into a bear market — typically defined as a sustained drop in stock prices of at least 20% — on June 13, 2022. When the market closed, the S&P 500 had dropped 21.8% from its January 3 peak, and the tech-heavy NASDAQ, already in bear territory, had plunged 32.7% from its November 19, 2021 peak.2

Some investors who are nervous about the future and their portfolios seem to have taken a defensive stance by selling riskier assets, including investments in growth-oriented technology stocks.

What’s causing market volatility?

Throughout 2021, U.S. businesses dealt with unpredictable demand shifts and supply shocks related to the pandemic, but near-zero interest rates and trillions of dollars in pandemic relief supported consumer spending, boosted economic growth, and drove record corporate profits. Companies in the S&P 500 posted profits in 2021 that were 70% higher than in 2020 and 33% higher than in 2019, which helped fuel a stock market total return of nearly 29%.3-4

But in the first months of 2022, investors began to worry that the anticipated tightening of monetary policies by the Federal Reserve — intended to cool off stubbornly high inflation — would stifle economic growth and cause a recession. Prices began rising in the spring of 2021 due to high demand, supply-chain issues, and a labor shortage that pushed up wages. Inflation picked up speed in the first quarter of 2022 when China’s COVID-19 lockdowns impacted the supply of goods, and Russia’s invasion of Ukraine sent already high global food and fuel prices through the roof. In May 2022, the Consumer Price Index rose at an annual rate of 8.6%, a 40-year high.5

The relentless acceleration of price increases puts pressure on the Federal Open Market Committee (FOMC), which meets on June 15 and 16, to act aggressively to tame inflation. At the beginning of May, the FOMC raised the benchmark federal funds rate by 0.5% (to a range of 0.75%–1.00%). This was the first half-percent increase since May 2000, and Fed projections suggest there will be more to come.6

Rising interest rates push bond yields upward, and the opportunity for higher returns from lower-risk bond investments makes higher-risk stock investments less attractive. Moreover, stock investors are buying a portion of a company’s future cash flows, which become less valuable in an inflationary environment. Higher borrowing costs can also crimp consumers’ spending power and cut into the profits of companies that rely on debt.

The problem with one sector dominating the market

Stocks tracked by the S&P Information Technology Sector Index, which fell 29.2% from a January 3 high, have been hit harder than the S&P 500. Plus, like many benchmark indexes, the S&P 500 is weighted by market capitalization (the value of a company’s outstanding shares). This gives the largest companies, most of which are in the tech sector, an outsized role in index performance. As of May 31, the information technology sector still accounted for 27.1% of the market cap of the S&P 500, compared with weightings of 14.4% for health care and 11.2% for financials, the next-largest sectors. Apple, Microsoft, Alphabet, and Amazon, respectively, are the four most-valuable companies in the index; Nvidia is ranked ninth and Meta has fallen to number 11.7

For the past several years, tech stock gains drove the market to new heights, but when their share values began to plunge, they dragged the broader stock indexes down with them. A Wall Street Journal analysis of market data through May 17 found that just eight of the largest U.S. companies — the six previously mentioned, plus Netflix and Tesla (in the consumer discretionary sector) — were responsible for an astounding 46% of the S&P 500’s 2022 losses (on a total return basis).8

These well-known technology companies have grown into massive multinational businesses that have a major influence on everyday life. Some dominate their respective business spaces — social media, smartphones, online search and advertising, e-commerce, and cloud computing — enough to spark antitrust investigations and calls for stricter regulations in the United States and abroad. They also have plenty of cash on hand, which means they may be in better shape to withstand an economic slowdown than their smaller competitors.9

Takeaways

Spreading investments among the 11 sectors of the S&P 500 is a common way to diversify stock holdings. But over time, a stock portfolio that was once diversified can become overconcentrated in a sector that has outperformed the broader market. Tech-sector stocks notched huge total returns of about 50% in 2019, 44% in 2020, and 35% in 2021, so you may want to look closely at the composition of your portfolio and consider rebalancing if you find yourself overexposed to this highly volatile sector. (Rebalancing involves selling some investments to buy others. Keep in mind that selling investments in a taxable account could result in a tax liability.) 10

If you feel shell-shocked after more than five months of market turbulence, try to regain some perspective. Some market analysts view recent price declines as a painful but long overdue repricing of stocks with valuations that had grown excessive, as well as a reality check brought on by waning growth expectations. The forward price-to-earnings (P/E) ratio of companies in the S&P 500 has fallen from 23.3 at the end of 2021 to 17.8 in May 2022, much closer to the 10-year average of 16.9.11-12

It could be a while before investors can better assess how the economy and corporate profits will ultimately fare against fast-rising inflation and higher borrowing costs — and the stock market is no fan of uncertainty. Disappointing economic data and company earnings reports could continue to spark volatility in the coming months.

It may not be easy to take troubling headlines in stride, but if you have a sufficiently diversified, all-weather investment strategy, sticking to it is often the wisest course of action. If you panic and flee the market during a downturn, you won’t be able to benefit from upward swings on its better days. And if you continue investing regularly for a long-term goal such as retirement, a down market may be an opportunity to buy more shares at lower prices.

The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Investments seeking a higher return tend to involve greater risk. Diversification is a method used to help manage risk. It does not guarantee a profit or protect against investment loss. The S&P 500 is an unmanaged group of securities that is considered representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is not a guarantee of future results. Actual results will vary. Dollar-cost averaging does not ensure a profit or prevent a loss. Such plans involve continuous investments in securities regardless of fluctuating prices. You should consider your financial ability to continue making purchases during periods of low and high price levels. However, this can be an effective way for investors to accumulate shares to help meet long-term goals.

1) SIFMA, 2022

2) Yahoo! Finance, 2022

3) The New York Times, May 31, 2022

4, 7, 10-11) S&P Dow Jones Indices, 2022

5) U.S. Bureau of Labor Statistics, 2022

6) Federal Reserve, 2022

8) The Wall Street Journal, May 19, 2022

9) The New York Times, May 20, 2022

12) FactSet, 2022

For the past several years, tech stock gains drove the market to new heights, but when their share values began to plunge, they dragged the broader stock indexes

13
May

The Question is How Long High Inflation Will Last?

at an annual rate of 8.5% in March 2022. That is the highest level since December 1981.1 A Gallup poll at the end of March found that one out of six Americans considers inflation to be the most important problem facing the United States.2 The Consumer Price Index for All Urban Consumers (CPI-U), the most common measure of inflation, rose

Many economists, including policymakers at the Federal Reserve, believed the increase would be transitory and subside over a period of months when inflation began rising in the spring of 2021. Inflation has proven to be more stubborn than expected. There are many reasons for the rising prices. The Fed has a plan to deal with the situation.

Russia and China contributed to the situation.

Among the cause of rising inflation are the growing pains of a rapidly opening economy, pent-up consumer demand, supply-chain slowdowns, and not enough workers to fill open jobs. Significant government stimulus and the Federal Reserve monetary policies helped prevent a deeper recession but contributed to an increase in inflation.

Russian invasion of Ukraine increased the  already high global fuel and food prices.3 China’s response to the reappearance of COVID’s was strict lockdowns, which closed factories and increased  already struggling supply chains for Chinese goods. The volume of cargo handled by the port of Shanghai, the world’s busiest port, dropped by an estimated 40% in early April.4

Behind the Headlines

8.5% year-over-year “headline” inflation in March was high. However, monthly numbers provide a clearer picture of the current trend. The month-over-month increase of 1.2% was extremely high, but more than half of it was due to gasoline prices, which rose 18.3% in March alone.5 Despite the Russia-Ukraine conflict and increased seasonal demand, U.S. gas prices dropped in April, but the trend was moving upward by the end of the month.6 The federal government’s decision to release one million barrels of oil per day from the Strategic Petroleum Reserve for the next six months and allow summer sales of higher-ethanol gasoline may help moderate prices.7

Core inflation, which strips out volatile food and energy prices, rose 6.5% year-over-year in March, the highest rate since 1982. However, the month-over-month increase from February to March was just 0.3%, the slowest pace in six months. Another positive sign was the price of used cars and trucks, which rose more than 35% over the last 12 months (a prime driver of general inflation) but dropped 3.8% in March.8

Wages and Consumer Demand

For the 12 months ended in March, average hourly earnings increased 5.6%. This was not enough to keep up with inflation, although it was enough to dulled some of the effects. Lower-paid service workers received higher increases, with wages jumping by almost 15% for nonmanagement employees in the leisure and hospitality industry. Although inflation has cut deeply into wage gains over the last year, wages have increased at about the same rate as inflation over the two-year period of the pandemic.9

One of the big questions going forward is whether rising wages will enable consumers to continue to pay higher prices, which can lead to an inflationary spiral of ever-increasing wages and prices. Recent signals are mixed. The official measure of consumer spending increased 1.1% in March, but an early April poll found that two out of three Americans had cut back on spending due to inflation.10-11

Soft or Hard Landing?

The Federal Open Market Committee (FOMC) of the Federal Reserve has laid out a plan to fight inflation by raising interest rates and tightening the money supply. After dropping the benchmark federal funds rate to near zero in order to stimulate the economy at the onset of the pandemic, the FOMC raised the rate by 0.25% at its March 2022 meeting and projected the equivalent of six more quarter-percent increases by the end of the year and three or four more in 2024.12 This would bring the rate to around 2.75%, just above what the FOMC considers a “neutral rate” that will neither stimulate nor restrain the economy.13

These moves were projected to bring the Fed’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) Price Index, down to 4.3% by the end of 2022, 2.7% by the end of 2023, and 2.3% by the end of 2024.14 PCE inflation was 6.6% in March. this tends to run below CPI, so even if the Fed achieves these goals, CPI inflation will likely remain somewhat higher.15

Fed policymakers have signaled a willingness to be more aggressive, if necessary, and the FOMC raised the funds rate by 0.5% at its May meeting, as opposed to the more common 0.25% increase. This was the first half-percent  increase since May 2000, and  there may be more to come. The FOMC also began reducing the Fed’s bond holdings to tighten the money supply. New projections to be released in June will provide an updated picture of the Fed’s intentions for the federal funds rate.16

The question facing the FOMC is how fast it can raise interest rates and tighten the money supply while maintaining optimal employment and economic growth. The ideal is a “soft landing,” like what occurred in the 1990s, when inflation was tamed without damaging the economy. At the other extreme is the “hard landing” of the early 1980s, when the Fed raised the funds rate to almost 20% to control runaway double-digit inflation, throwing the economy into a recession.18

Fed Chair Jerome Powell acknowledges that a soft landing will be difficult to achieve, but he believes the strong job market may help the economy withstand aggressive monetary policies. Supply chains are expected to improve over time, and workers who have not yet returned to the labor force might fill open jobs without increasing wage and price pressures.19

The next few months will be a key period to reveal the future direction of inflation and monetary policy. The hope is that March represented the peak and inflation will begin to trend downward. But even if that proves to be true, it could be a painfully slow descent.

Projections are based on current conditions, are subject to change, and may not happen.

1, 5, 8-9) U.S. Bureau of Labor Statistics, 2022

2) Gallup, March 29, 2022

3, 7) The New York Times, April 12, 2022

4) CNBC, April 7, 2022

6) AAA, April 25 & 29, 2022

10, 15) U.S. Bureau of Economic Analysis, 2022

11) CBS News, April 11, 2022

12, 14, 16) Federal Reserve, 2022

13, 17) The Wall Street Journal, April 18, 2022

18) The New York Times, March 21, 2022

30
Mar

Managing Bond Risks When Interest Rates Rise

After dropping the benchmark federal funds rate to a rock-bottom range of 0%–0.25% early in the pandemic, the Federal Open Market Committee has begun raising the rate toward more typical historical levels in response to high inflation. At its March 2022 meeting, the Committee raised the funds rate to 0.25%–0.50% and projected the equivalent of six more quarter-percentage-point increases in 2022 and three or four more in 2023.1

Raising the federal funds rate places upward pressure on a wide range of interest rates, including the cost of borrowing through bond issues. Regardless of the rate environment, however, bonds are a mainstay for  investors who want to generate income or dampen the effects of stock market volatility on their portfolios. You may have questions about how higher rates could affect your fixed-income investments and what you can do to help mitigate the effect in your portfolio.

Rate sensitivity

When interest rates rise, the value of existing bonds typically falls, because investors would prefer to buy new bonds with higher yields. In a rising rate environment,  investors may be hesitant to tie up funds for a lengthy period, so bonds with longer maturity dates are generally more sensitive to rate changes than shorter-dated bonds. Thus, one way to address interest-rate sensitivity in your portfolio is to hold short- and medium-term bonds. However, keep in mind that although these bonds may be less sensitive to rate changes, they will generally offer a lower yield than longer-term bonds.

A more specific measure of interest-rate sensitivity is called duration. A bond’s duration is derived from a complex calculation that includes the maturity date, the present value of principal and interest to be received in the future, and other factors. To estimate the impact of a rate change on a bond investment, multiply the duration by the expected percentage change in interest rates. For example, if interest rates rise by 1%, a bond  or bond fund with a three-year duration might be expected to lose roughly 3% in value; one with a seven-year duration might fall by about 7%. Your investment professional or brokerage firm can provide information about the duration of your bond investments.

If two bonds have  the same maturity, the bond with the higher yield will typically have a shorter duration. For this reason, U.S. Treasuries tend to be more rate sensitive than corporate bonds of similar maturities. Treasury securities, which are backed by the federal government as to the timely payment of principal and interest, are considered lower risk and thus can pay lower rates of interest than corporate bonds. A five-year Treasury bond has a duration of less than five years, reflecting income payments received prior to maturity. However, a five-year corporate bond with a higher yield has an even shorter duration.

When a bond is held to maturity, the bond owner would receive the face value and interest, unless the issuer defaults. However, bonds redeemed prior to maturity may be worth more or less than their original value. Thus, rising interest rates should not affect the return on a bond you hold to maturity, but may affect the price of a bond you want to sell on the secondary market before it reaches maturity.

Bond ladders

Owning a diversified mix of bond types and maturities can help reduce the level of risk in the fixed-income portion of your  portfolio. One structured way to take this risk management approach is to construct a bond ladder, a portfolio of bonds with maturities that are spaced  at regular intervals over a certain number of years. For example, a five-year ladder might have 20% of the bonds mature each year.

Bond ladders may vary in size and structure, and could include several types of bonds depending on an investor’s time horizon, risk tolerance, and goals. As bonds in the lowest rung of the ladder mature, the funds are often reinvested at the long end of the ladder. By doing so, investors may be able to increase their cash flow by capturing higher yields on new issues. A ladder might also be part of a withdrawal strategy in which the returned principal from maturing bonds provides retirement income.

In the current situation, with rates projected to rise over a two- to three-year period, it might make sense to create a short bond ladder now and a longer ladder when rates appear to have stabilized. Keep in mind that the anticipated path of the federal funds rate is only a projection, based on current conditions, and may not happen. The actual direction of interest rates might change.

Laddering ETFs and UITs

Building a ladder with individual bonds provides certainty if the bonds are held to maturity, but it can be expensive. Individual bonds typically require a minimum purchase of at least $5,000 in face value, so creating a diversified bond ladder might require a sizable investment. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.

A similar approach involves laddering bond exchange-traded funds (ETFs) that have defined maturity dates. These funds, typically called target-maturity funds, generally hold many bonds that mature in the same year the ETF will liquidate and return assets to shareholders. Target maturity ETFs may enhance diversification and provide liquidity, but unlike individual bonds, the income payments and final distribution rate are not fully predictable.

Another option is to purchase unit investment trusts (UITs) with staggered termination dates. Bond-based UITs typically hold a varied portfolio of bonds with maturity dates that coincide with the trust termination date, at which point you could reinvest the proceeds as you wish. The UIT sponsor may offer investors the opportunity to roll over the proceeds to a new UIT, which typically incurs an additional sales charge.

Bond funds

Bond funds — mutual funds and ETFs composed mostly of bonds and other debt instruments — are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. Thus, falling bond prices due to rising rates can adversely affect a bond fund’s performance. Because longer-term bonds are generally more sensitive to rising rates, funds that hold short- or medium-term bonds may be more stable as rates increase.

Bond funds do not have set maturity dates (except for the target maturity ETFs discussed above), because they typically hold bonds with varying maturities, and they can buy and sell bonds before they mature. So, you might consider the fund’s duration, which considers the durations of the underlying bonds. The longer the duration, the more sensitive a fund is to changes in interest rates. You can usually find duration with other information about a bond fund. Although helpful as a general guideline, duration is best used when comparing funds with similar types of underlying bonds.

A fund’s sensitivity to interest rates is only one aspect of its value — fund performance can be driven by a variety of dynamics in the market and the broader economy. Moreover, as underlying bonds mature and are replaced by higher-yielding bonds in a rising interest rate environment, the fund’s yield and/or share value could potentially increase over the long term. Even in the short term, interest paid by the fund could help moderate any losses in share value.

It’s also important to remember that fund managers might respond differently if falling bond prices adversely affect a fund’s performance. Some might try to preserve the fund’s asset value at the expense of its yield by reducing interest payments. Others might emphasize preserving a fund’s yield at the expense of its asset value by investing in bonds of longer duration or lower credit quality that pay higher interest but carry greater risk. Information on a fund’s management, objectives, and flexibility in meeting those objectives is spelled out in the prospectus and may be available with other fund information online.

The return and principal value of individual bonds, UIT units, and mutual fund and ETF shares fluctuate with changes in market conditions. Fund shares and UIT units, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. ETFs typically have lower expense ratios than mutual funds, but you may pay a brokerage commission whenever you buy or sell ETFs, so your overall costs could be higher, especially if you trade frequently. Supply and demand for ETF shares may cause them to trade at a premium or a discount relative to the value of the underlying shares. UITs may carry additional risks, including the potential for a downturn in the financial condition of the issuers of the underlying securities. There may be tax consequences associated with the termination of the UIT and rolling over an investment into a successive UIT. There is no assurance that collaborating with a financial professional will improve investment results.

1) Federal Reserve, March 16, 2022

17
Mar

What Do Rising Interest Rates Mean for You?

On March 16, 2022, the Federal Open Market Committee (FOMC) of the Federal Reserve raised the benchmark federal funds rate by 0.25% to a target range of 0.25% to 0.50%. This is the beginning of a series of increases that the FOMC expects to conduct over the next two years to combat high inflation.1

The FOMC released economic projections that suggest the equivalent of six  additional 0.25% increases in 2022, followed by three or four more increases in 2023 when it announced the current increase, 2 These are only projections, based on current conditions, and may not happen. However, they provide a helpful picture of the potential direction of U.S. interest rates.

What is the federal funds rate?

The federal funds rate is the interest rate at which banks lend funds to each other overnight to maintain legally required reserves within the Federal Reserve System. The FOMC sets a target range, usually a 0.25% spread, and then sets two specific rates that function as a floor and a ceiling to push the funds rate into that target range. The rate may vary slightly from day to day, but it generally stays within the target range.

Although the federal funds rate is an internal rate within the Federal Reserve System, it serves as a benchmark for many short-term rates set by banks and can influence longer-term rates as well.

Why does the Fed adjust the federal funds rate?

The Federal Reserve and the FOMC operate under a dual mandate to conduct monetary policies that foster maximum employment and price  stability. Adjusting the federal funds rate is the Fed’s primary tool to influence economic growth and inflation.

The FOMC lowers the federal funds rate to stimulate the economy by making it easier for businesses and consumers to borrow, and raises the rate to combat inflation by making borrowing more expensive. In March 2020, when the U.S. economy was devastated by the pandemic, the Committee quickly     dropped the rate to its rock-bottom level of 0.00%–0.25% and has kept it there for two years as the economy recovered.

The FOMC has set a 2% annual inflation goal as consistent with healthy economic growth. The Committee considered it appropriate for inflation to run above 2% for some time to balance the extended period when it ran below 2% and give the economy more time to grow in a low-rate environment. However, the steadily increasing inflation levels over the last year — with no sign of easing — have forced the Fed to change course and tighten monetary policy.

How will consumer interest rates be affected?

The prime rate, which commercial banks charge their best customers, is tied directly to the federal funds rate, and generally runs about 3% above it. Though actual rates can vary widely, small-business loans, adjustable-rate mortgages, home-equity lines of credit, auto loans, credit cards, and other forms of consumer credit are often linked to the prime rate, so the rates on these types of loans typically increase with the federal funds rate. Fixed-rate home mortgages are not tied directly to the federal funds rate or the prime rate. Although Fed rate hikes may put upward pressure on new mortgage rates.

Rising interest rates make it more expensive for consumers and businesses to borrow. Although, retirees and others who seek income could eventually benefit from higher yields on savings accounts and certificates of deposit (CDs). Banks typically raise rates charged on loans more quickly than they raise rates paid on deposits, but an extended series of rate increases should filter down to savers over time.

What about bond investments?

Interest-rate changes can have a broad effect on investments, but the impact tends to be more pronounced in the short term as markets adjust to the new level.

When interest rates rise, the value of existing bonds typically falls. Put simply, investors would prefer a newer bond paying a higher interest rate than an existing bond paying a lower rate. Longer-term     bonds tend to fluctuate more than those with shorter maturities because investors may be reluctant to tie up their money for an extended period if they anticipate higher yields in the future.

Bonds redeemed prior to maturity may be worth more or less than their original value, but when a bond is held to maturity, the bond owner would receive the face value and interest, unless the issuer defaults. Thus, rising interest rates should not affect the return on a bond you hold to maturity, but may affect the price of a bond you want to sell on the secondary market before it reaches maturity.

Although the rising-rate environment may have a negative impact on bonds you currently hold and want to sell, it might also offer more appealing rates for future bond purchases.

Bond funds are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. Thus, falling bond values due to rising rates can adversely affect a bond fund’s performance. However, as underlying bonds mature and are replaced by higher-yielding bonds within a rising interest-rate environment, the fund’s yield and/or share value could potentially increase over the long term.

How will the stock market react?

Equities may also be affected by rising rates, though not as directly as bonds. Stock prices are closely tied to earnings growth, so many corporations stand to benefit from a more robust economy, even with higher interest rates. On the other hand, companies that rely on heavy borrowing will likely face higher costs going forward, which could affect their bottom lines.

The stock market reacted positively to the initial rate hike and the projected path forward, but investors will be watching closely to see how the economy performs as interest rates adjust — and whether the increases are working to tame inflation.3

The market may continue to react, positively or negatively, to the government’s inflation reports or the Fed’s interest-rate decisions, but any reaction is typically temporary. As always, it’s important to maintain a long-term perspective and make sound investment decisions based on your own financial goals, time horizon, and risk tolerance.

The FDIC insures CDs and bank savings accounts, which generally provide a fixed rate of return, up to $250,000 per depositor, per insured institution. The return and principal value of stocks and investment     funds fluctuate with market conditions. Shares, when sold, may be worth more or less than their original cost. Investments offering the potential for higher rates of return also involve higher risk.

Investment funds are sold by prospectus. Please consider the fund’s objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the     prospectus carefully before deciding whether to invest.

1–2) Federal Reserve, March 16, 2022

3) The Wall Street Journal, March 17, 2022

3
Nov

Budget and Debt Ceiling Vagueness

On September 30, 2021, Congress averted a potential federal government shutdown by passing a last-minute bill to fund government operations through December 3, 2021.1 Two weeks later, another measure raised the debt ceiling by just enough to sustain federal borrowing until about the same date.2 Although these bills provided temporary relief, they did not resolve the fundamental issues, and Congress will have to act again by December 3.

Spending vs. Borrowing

The budget and the debt ceiling are often considered together by Congress, but they are separate fiscal issues. The budget authorizes future spending, while the debt ceiling is a statutory limit on federal borrowing necessary to fund already authorized spending. Thus, increasing the debt ceiling does not increase government spending. But it does allow borrowing to meet increased spending authorized by Congress.

The underlying fact in this relationship between the budget and the debt ceiling is that the U.S. government runs on a deficit and has done so every year since 2002.3 The U.S. Treasury funds the deficit by borrowing through securities such as Treasury notes, bills, and bonds. When the debt ceiling is reached, the Treasury can no longer issue securities that would put the government above the limit.

Twelve Appropriations Bills

The federal fiscal year begins on October 1, and 12 appropriations bills for various government sectors should be passed by that date to fund activities ranging from defense and national park operations to food safety and salaries for federal employees.4 These appropriations for discretionary spending account for about one-third of federal spending, with the other two-thirds, including Social Security and Medicare, prescribed by law.5

Though it would be better for federal agencies to know their operating budgets at the beginning of the fiscal year, the deadline to pass all 12 bills has not been met since FY 1997.6 This year, none of the bills had passed as of late October.7

To delay for further budget negotiations, Congress typically passes a continuing resolution, which extends federal spending to a specific date based on a fixed formula. The September 30 resolution extended spending to December 3 at FY 2021 levels.8 Adding to the stakes of this year’s budget negotiations, spending caps on discretionary spending that were enacted in 2011 expired on September 30, 2021, so FY 2022 budget levels may become the baseline for future spending.9

Raising the Ceiling

A debt limit was first established in 1917 to facilitate government borrowing during World War I. Since then, the limit has been raised or suspended almost 100 times, often with little or no conflict.10 However, in recent years, it has become more contentious. In 2011, negotiations came so close to the edge that Standard & Poor’s downgraded the U.S. government credit rating.11

A two-year suspension expired on August 1 of this year. At that time, the federal debt was about $28.4 trillion, with large recent increases due to the $3 trillion pandemic stimulus passed with bipartisan support in 2020, as well as the 2021 American Rescue Plan and continuing effects of the Tax Cuts and Jobs Act of 2017.12-13 The Treasury funded operations after August 1 by employing certain “extraordinary measures” to maintain cash flow. Treasury Secretary Janet Yellen projected that these measures would be exhausted by October 18.14

The bill signed on October 14 increased the debt ceiling by $480 billion, the amount the Treasury estimated would be necessary to pay government obligations through December 3, again using extraordinary measures. Unlike the budget extension, which is a hard deadline, the debt ceiling date is an estimate, and the Treasury may have a little breathing room.15–16

Potential Consequences

If the budget appropriations bills — or another continuing resolution — are not passed by December 3, the government will be forced to shut down unfunded operations, except for some essential services. This occurred in fiscal years 2013, 2018, and 2019, with shutdowns lasting 16 days, 3 days, and 35 days, respectively.

Although the consequences of a government shutdown would be serious, the economy has bounced back from previous shutdowns. By contrast, a U.S. government default would be unprecedented and could result in unpaid bills, higher interest rates, and a loss of faith in U.S. Treasury securities that would reverberate throughout the global economy. The Federal Reserve has a contingency plan that might mitigate the effects of a short-term default, but Fed Chair Jerome Powell has emphasized that the Fed could not “shield the financial markets, and the economy, and the American people from the consequences of default.”17

Given the stakes, it is unlikely that Congress will allow the government to default, but the road to raising the debt ceiling is unclear. The temporary measure was passed through a bipartisan agreement to suspend the Senate filibuster rule, which effectively requires 60 votes to move most legislation forward. However, this was a one-time exception and may not be available again. Another possibility may be to attach a provision to the education, healthcare, and climate package slated to move through a complex budget reconciliation process that allows a bill to bypass the Senate filibuster. However, the reconciliation process is time-consuming, and it is not clear whether the debt ceiling would meet parliamentary requirements.18

The budget and the debt ceiling are serious issues, but Congress has always found a way to resolve them in the past. It’s generally wise to maintain a long-term investment strategy based on your goals, time frame, and risk tolerance, rather than overreacting to political conflict and any resulting market volatility.

U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. All investments are subject to market fluctuation, risk, and loss of principal. When sold, investments may be worth more or less than their original cost.

Planning is further complicated by the uncertainty as to what changes, if any, will be made relating to income, estate and gift tax provisions and their effective dates. Individual circumstances will differ. Review your situation and planning to determine what if any actions is required. Pay close attention to your current and expected future tax brackets when you consider the timing of deductions and income.

1, 8) The Washington Post, September 30, 2021

2, 16, 18) Barron’s, October 15, 2021

3) U.S. Office of Management and Budget, 2021

4, 7, 9) Committee for a Responsible Federal Budget, June 25, 2021; October 18, 2021

5, 11, 14, 17) The Wall Street Journal, September 28, 2021

6) Peter G. Peterson Foundation, October 1, 2021

10) NPR, September 28, 2021

12, 15) U.S. Treasury, 2021

13) Moody’s Analytics, September 21, 2021

19
Oct

Is the Back-Door Roth IRA Going Away for Good?

Among the many provisions in the multi-trillion-dollar legislative package being debated in Congress is a provision that would eliminate a strategy that allows high-income investors to pursue tax-free retirement income: the so-called back-door Roth IRA. The next few months may present the last chance to take advantage of this opportunity.

Roth IRA Background
Since its introduction in 1997, the Roth IRA has become an attractive investment vehicle due to the potential to build a sizable, tax-free nest egg. Although contributions to a Roth IRA are not tax deductible, any earnings in the account grow tax-free if future distributions are qualified. A qualified distribution is one made after the Roth account has been held for five years and after the account holder reaches age 59½, becomes disabled, dies, or uses the funds for the purchase of a first home ($10,000 lifetime limit).

Unlike other retirement savings accounts, original owners of Roth IRAs are not subject to required minimum distributions at age 72 — another potentially tax-beneficial benefit that makes Roth IRAs appealing in estate planning strategies. (Beneficiaries are subject to distribution rules.)

However, as initially passed, the 1997 legislation rendered it impossible for high-income taxpayers to enjoy Roth IRAs. Individuals and married taxpayers whose income exceeded certain thresholds could neither contribute to a Roth IRA nor convert traditional IRA assets to a Roth IRA.

A Loophole Emerges
Nearly 10 years after the Roth’s introduction, the Tax Increase Prevention and Reconciliation Act of 2005 ushered in a change that relaxed the conversion rules beginning in 2010; that is, as of that year, the income limits for a Roth conversion were eliminated, which meant that anyone could convert traditional IRA assets to a Roth IRA. (Of course, a conversion results in a tax obligation on deductible contributions and earnings that have previously accrued in the traditional IRA.)

One perhaps unintended consequence of this change was the emergence of a new strategy that has been utilized ever since: High-income individuals could make full, annual, nondeductible contributions to a traditional IRA and convert those contribution dollars to a Roth. If the account holders had no other IRAs (see note below) and the conversion was executed quickly enough so that no earnings were able to accrue, the transaction could potentially be a tax-free way for otherwise ineligible taxpayers to fund a Roth IRA. This move became known as the back-door Roth IRA.

(Note: When calculating a tax obligation on a Roth conversion, investors must aggregate all their IRAs, including SEP and SIMPLE IRAs, before determining the amount. For example, say an investor has $100,000 in several different traditional IRAs, 80% of which is attributed to deductible contributions and earnings. If that investor chose to convert any traditional IRA assets — even recent after-tax contributions — to a Roth IRA, 80% of the converted funds would be taxable. This is known as the “pro-rata rule.”)

Current Roth IRA Income Limits
For 2021, you can generally contribute up to $6,000 to an IRA (traditional, Roth, or a combination of both); $7,000 if you’ll be age 50 or older by December 31. However, your ability to make contributions to a Roth IRA is limited or eliminated if your modified adjusted gross income, or MAGI, falls within or exceeds the parameters shown below.

If your federal filing status is:Your 2021 Roth IRA contribution is reduced if your MAGI is:You can’t contribute to a Roth IRA for 2021 if your MAGI is:
Single or head of householdMore than $125,000 but less than $140,000$140,000 or more
Married filing jointly or qualifying widow(er)More than $198,000 but less than $208,000$208,000 or more
Married filing separatelyLess than $10,000$10,000 or more

Note that your contributions generally can’t exceed your earned income for the year (special rules apply to spousal Roth IRAs).

Now or Never … Maybe
While no one knows for sure what may come of the legislative debates, the current proposal would prohibit the conversion of nondeductible contributions from a traditional IRA after December 31, 2021. If you expect your MAGI to exceed this year’s thresholds and you’d like to fund a Roth IRA for 2021, the next few months may be your last chance to use the back-door strategy. Contact your financial and tax professionals for more information.

There is no assurance that working with a financial professional will improve investment results.

You can make 2021 IRA contributions up until April 15, 2022, but if the legislation is enacted, a Roth conversion involving nondeductible contributions would have to be conducted by December 31, 2021.

Keep in mind that a separate five-year rule applies to the principal amount of each Roth IRA conversion you make unless an exception applies.

8
Jul

Should You Be Concerned About Inflation?

If you pay attention to financial news, you are probably seeing a lot of discussion about inflation, which has reared its head in the U.S. economy after being mostly dormant for the last decade. In May 2021, the Consumer Price Index for All Urban Consumers (CPI-U), often called headline inflation, rose at an annual rate of 5.0%, the highest 12-month increase since August 2008.1

The CPI-U measures the price of a fixed market basket of goods and services purchased by residents of urban and metropolitan areas — about 93% of the U.S. population. You have likely seen price increases in some of the goods and services you purchase, and if so it’s natural to be concerned.

The larger question is whether these price increases are temporary, caused by factors such as supply-chain issues and labor shortages that will be resolved as the economy continues to emerge from the pandemic, or whether they indicate a fundamental imbalance that could cause widespread long-term inflation and hold back economic growth.

Most economists — including Federal Reserve Chair Jerome Powell and Treasury Secretary Janet Yellen — believe the current spike is primarily due to transitory factors that will fade in the coming months. One example of this, cited by Powell in a recent press conference, is the price of lumber.2–3

Supply and Demand

Early in the pandemic, many lumber mills shut down or cut back on production because they expected a major slowdown in building. In fact, demand for housing and home renovation increased during the pandemic, as many people who worked from home wanted more space, a different location, or  improvements to their current homes. Low supply and high demand sent lumber prices soaring.4

Sawmills geared up as quickly as they could and were reaching full capacity just as demand began to ebb, with builders cutting back due to high prices and homeowners using their discretionary income to buy other goods and services. Suddenly the supply exceeded demand, and prices began to drop. Wholesale lumber prices are still higher than before the pandemic, and it takes time for price drops to filter down to the retail level, but it’s clear that the extreme inflation was transitory and has been reversed. The lumber story also suggests that consumers and businesses will cut back on spending for a product that becomes too expensive rather than spend at any price and feed an inflationary spiral.5

Chips and Cars

Another example of pandemic-driven imbalance between supply and demand is used car and truck prices, which have skyrocketed almost 30% over the last 12 months and represent a substantial portion of the overall increase in CPI. Used vehicles are hard to find in large part because fewer new cars are being built — and fewer new cars are being built because there is a shortage of computer chips. A single new car can require more than 1,000 chips, and when auto manufacturers were forced to close their factories early in the pandemic and new vehicle sales plummeted due to lack of demand, chip manufacturers shifted from producing chips for cars to producing chips for high-demand consumer electronics such as webcams, phones, and laptops.6–8

As the economy reopened and the demand for cars increased, chip producers were unable to shift and increase production quickly enough to meet the needs of auto manufacturers. The chip shortage is expected to reduce global auto production by 3.9 million vehicles in 2021, a drop of 4.6%. Unlike lumber, the chip shortage may take some time to resolve, because chip manufacturing is a long, multi-step process and most chips are manufactured outside the United States. The federal government has stepped in to encourage U.S. manufacturers to build new facilities and increase production.9

Fundamental Forces

Imbalances between supply and demand are to be expected as the economy reopens, and most such imbalances should work themselves out in the marketplace. But other forces could fuel more extensive inflation. Massive federal stimulus packages have provided consumers with more money to spend, while ongoing stimulus from the Federal Reserve has increased the money supply and made it easier to borrow.

Although unemployment is still relatively high at 5.9%, millions of jobs remain open as workers are hesitant to return to positions they consider unsafe in light of the pandemic, are unable to work due to lack of child care, and/or are rethinking their careers in a post-pandemic world.10–11This may change in September as extended unemployment benefits expire and children return to school, but the current imbalance is forcing many businesses to raise wages, especially in lower-paying jobs.12

The increases so far are primarily “catching up” after many years of low wages and should be absorbed by businesses or passed on to consumers with moderate price increases.13 However, if wages and prices increase too quickly and consumers earning higher wages are willing to spend regardless of rising prices — because they expect prices to rise even higher — the wage-price inflation spiral could be difficult to control.

Reading the Economy

When considering the current situation, it’s helpful to look at other measures of inflation.

Base effect. On a purely mathematical level, high 12-month CPI increases in March, April, and May 2021 reflect the fact that the CPI is being compared with those months in 2020, when prices decreased as the economy closed in response to the pandemic. This comparison to unusually low numbers is called the base effect. To avoid this effect, it’s helpful to look at annualized inflation over a two-year period, comparing prices now with prices before the pandemic. By that measure, current inflation is about 2.5%, a little higher than the average over the last decade but not nearly as concerning as a 5.0% level.14

Core inflation. Prices of some items are more volatile than others, and food and energy are especially volatile categories that can change quickly even in a low-inflation environment. For this reason, economists tend to look more carefully at core inflation, which strips out food and energy prices and generally runs lower than CPI-U. Core CPI rose at an annual rate of 3.8% in May 2021, which sounds better than 5.0% until you consider that it is the highest core inflation since June 1992. The good news is that the 0.7% monthly increase from April to May was lower than the 0.9% rise from March to April, suggesting that core inflation may be slowing down.  (The CPI-U increase also slowed in May, rising 0.6% for the month after a 0.8% increase in April.)15

Sticky prices.  Another helpful measure is the sticky-price CPI, which sorts the components of the CPI into categories that are relatively slow to change (sticky) and those that change more rapidly (flexible). The sticky price CPI increased just 2.7% over the 12-month period ending in May 2021. By contrast, the flexible component of the CPI increased 12.4% over the year.16 This suggests that a variety of factors — such as problems with supply chains, labor, and extreme weather — may be moving prices on flexible items, but that underlying economic forces are moving more stable prices at a relatively moderate rate.

The Fed’s Arsenal

The Federal Open Market Committee (FOMC), an arm of the Federal Reserve, is charged with setting economic policy to meet its dual mandate of fostering maximum employment while promoting price stability. The Fed’s primary economic tools are the benchmark federal funds rate, which affects many other interest rates, and its bond-buying program, which injects liquidity into the economy. Put simply, the Fed lowers the funds rate and buys bonds to stimulate the economy and increase employment, and raises the rate and stops buying bonds or sells bonds to put the brakes on inflation.

The federal funds rate has been at its rock-bottom range of 0.0% to 0.25% since March 2020, when the Fed dropped it quickly in the face of the pandemic, and the Federal Reserve is buying $120 billion in government bonds every month, much less than it did early in the pandemic but still a substantial and steady injection of money into the economy.17 (Unlike an individual or a regular bank that must spend money to purchase bonds, the central bank buys bonds by creating an electronic deposit in one of its member banks, thus creating “new money” that can be used to lend and circulate into the economy.)

Some inflation is necessary for economic growth — without it, an economy is stagnant — and in 2012, the FOMC set a 2% target for healthy inflation, based on a measure called the Personal Consumption Expenditures (PCE) Price Index. The PCE price index uses much of the same data as the CPI, but it captures a broader range of expenditures and reflects changes in consumer spending.

More specifically, the FOMC focuses on core PCE (excluding food and energy), which remained below the 2% target for most of the last decade. In August 2020, the FOMC changed its policy to target an average PCE inflation rate of 2% and indicated it would allow inflation to run higher for some time to balance the time it ran below the target. This is the current situation. Core PCE increased at a 12-month rate of 3.4% in May 2021, but so far the Fed has shown little inclination to take action in the short term.18 The FOMC projects PCE inflation to drop to 3.1% by the end of the year and to 2.1% by the end of 2022.19

At its June meeting, the FOMC did indicate an important shift by projecting the federal funds rate would increase in 2023 to a range of 0.5% to 0.75%, effectively two quarter-point steps.  (In March, the projection had been to hold the rate steady at least through 2023.) Fed Chair Powell also indicated that the FOMC has begun “talking about talking about” reducing the monthly bond purchases.20 Neither of these signals suggests any immediate action or serious concern about inflation. However, the fact that the funds rate remains near zero and that the Fed continues to buy bonds gives the central bank powerful “weapons” to employ if it believes inflation is increasing too quickly.

The next few months may indicate whether inflation is slowing down or changes in monetary policy are necessary. Unfortunately, prices do not always come down once they rise, but it may be helpful to keep in mind that prices of many goods and services did decline during the pandemic, and the higher prices you are seeing today might not be far out of line compared with prices before the economic slowdown. As long as inflation begins trending downward, it seems likely that the current numbers reflect growing pains of the recovery rather than a long-term threat to economic growth.

U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, bonds could be worth more or less than the original amount paid. Projections are based on current conditions, are subject to change, and may not come to pass.

1, 6, 10, 14) U.S. Bureau of Labor Statistics, 2021

2, 17, 19–20) Federal Reserve, 2021

3) Bloomberg, June 5, 2021

4–5) The New York Times, June 21, 2021

7) CBS News, June 22, 2021

8–9) Time, June 28, 2021

11) CNBC, June 8, 2021

12–13) CNBC, May 22, 2021

15) The Wall Street Journal, June 22, 2021

16) Federal Reserve Bank of Atlanta, 2021

18) U.S. Bureau of Economic Analysis, 2021

5
May

Rising Inflation: Where Will It Go from Here?

In March 2021, the Consumer Price Index for All Urban Consumers (CPI-U) rose 0.6%, the largest one-month increase since August 2012. Over the previous 12 months, the increase was 2.6%, the highest year-over-year inflation rate since August 2018. (By contrast, inflation in 2020 was just 1.4%.). 1

The annual increase in CPI-U — often called headline inflation — was due in part to the fact that the index dropped in March 2020, the beginning of the U.S. economic shutdown in the face of the COVID-19 pandemic. Thus, the current 12-month comparison is to an unusual low point in prices. The index dropped even further in April 2020, and this “base effect” will continue to skew annual data through June. 2

The monthly March increase, which followed a substantial 0.4% increase in February, is more indicative of the current situation. Economists expect inflation numbers to rise for some time. The question is whether they represent a temporary anomaly or the beginning of a more worrisome inflationary trend. 3

Measuring Prices

In considering the prospects for inflation, it’s important to understand some of the measures that economists use.

CPI-U measures the price of a fixed market basket of goods and services. As such, it is a good measure of prices consumers pay if they buy the same items over time, but it does not reflect changes in consumer behavior and can be unduly influenced by extreme increases in specific categories. Nearly half of the March increase was due to gasoline prices, which rose 9.1% during the month, in part because of production interruptions caused by severe winter storms in Texas.4 Core CPI, which strips out volatile food and energy prices, rose 0.3% in March and just 1.6% year over year. 5

In setting economic policy, the Federal Reserve prefers a different inflation measure called the Personal Consumption Expenditures (PCE) Price Index, which is even broader than the CPI and adjusts for changes in consumer behavior — i.e., when consumers shift to purchase a different item because the preferred item is too expensive. More specifically, the Fed looks at core PCE, which rose 0.4% in March and 1.8% for the previous 12 months, slightly higher than core CPI but still lower than the Fed’s target of 2% for healthy economic growth. 6

A Hot Economy

Based on the core numbers, inflation is not yet running high, but there are clear inflationary pressures on the U.S. economy. Loose monetary policies by the central bank and trillions of dollars in government stimulus could create excess money supply as the economy reopens. Pent-up consumer demand for goods and services is likely to rise quickly, fueled by stimulus payments and healthy savings accounts built by those who worked through the pandemic with little opportunity to spend their earnings. Businesses that shut down or cut back when the economy was closed may not be able to ramp up quickly enough to meet demand. Supply-chain disruptions and higher costs for raw materials, transportation, and labor have already led some businesses to raise prices. 7

According to the April Wall Street Journal Economic Forecasting Survey, gross domestic product (GDP) is expected to increase at an annualized rate of 8.4% in the second quarter of 2021 and by 6.4% for the year — a torrid annual growth rate that would be the highest since 1984. As with the base effect for inflation, it’s important to keep in mind that this follows a 3.5% GDP decline in 2020. Even so, the expectation is for a hot economy through the end of the year, followed by solid 3.2% growth in 2022 before slowing down to 2.4% in 2023. 8-9

Three Scenarios

Will the economy get too hot to handle? Though all economists expect inflation numbers to rise in the near term, there are three different views on the potential long-term effects.

The most sanguine perspective, held by many economic policymakers including Federal Reserve Chair Jerome Powell and Treasury Secretary Janet Yellen, is that the impact will be short-lived and due primarily to the base effect with little or no long-term consequences. 10 Inflation has been abnormally low since the Great Recession, consistently lagging the Fed’s 2% target. In August 2020, the Federal Open Market Committee (FOMC) announced that it would allow inflation to run moderately above 2% for some time in order to create a 2% average over the longer term. Given this policy, the FOMC is unlikely to raise interest rates unless core PCE inflation runs well above 2% for an extended period. 11 The mid-March FOMC projection sees core PCE inflation at just 2.2% by the end of 2021, and the benchmark federal funds rate remaining at 0.0% to 0.25% through the end of 2023. 12

The second view believes that inflation may last longer, with potentially wider consequences, but that any effects will be temporary and reversible. The third perspective is that inflation could become a more extended problem that may be difficult to control. Both camps project that the base effects will be amplified by “demand-pull” inflation, where demand exceeds supply and pushes prices upward. The more extreme view believes this might lead to a “cost-push” effect and inflationary feedback loop where businesses, faced with less competition and higher costs, would raise prices preemptively, and workers would demand higher wages in response. 13

Maintaining Perspective

Although it’s too early to tell whether current inflation numbers will lead to a longer-term shift, you can expect higher prices for some items as the economy reopens. Consumers don’t like higher prices, but it’s important to keep these increases in perspective. Gasoline, jet fuel, and other petroleum prices are rising after being deeply depressed during the pandemic. Airline ticket prices are increasing but remain below their pre-pandemic level. Used cars and trucks are more expensive than before the pandemic, but clothing is still cheaper. 14 Food is up 3.5% over the last 12 months, a significant increase but not extreme for prices that tend to be volatile. 15

For now, it may be helpful to remember that “headline inflation” does not always represent the larger economy. And with interest rates near zero, the Federal Reserve has plenty of room to make any necessary adjustments to monetary policy.

Projections are based on current conditions, are subject to change, and may not come to pass.

1, 5, 15) U.S. Bureau of Labor Statistics, 2021

2-4, 7) The Wall Street Journal, April 13, 2021

6, 9) U.S. Bureau of Economic Analysis, 2021

8) The Wall Street Journal Economic Forecasting Survey, April 2021

10, 13) Bloomberg, March 29, 2021

11) The Wall Street Journal, April 14, 2021

12) Federal Reserve, 2021

14) The New York Times, April 13, 2021

7
Apr

High-Frequency Indicators: Where to Look for Signs of Recovery

Since the pandemic began, disruptions in business activity have varied greatly from region to region, and often from one week to the next, according to the severity of local COVID-19 outbreaks. Unfortunately, many of the official government statistics used to gauge the health of the U.S. economy are backward looking and somewhat delayed.

Changes in the nation’s gross domestic product (GDP) indicate the rate at which the economy is growing or shrinking, but the first GDP estimate is not published by the Bureau of Economic Analysis until about one month after each quarter ends. GDP increased at a 4.3% rate in the fourth quarter of 2020 but posted the worst annual decline (-3.5%) since 1946. 1.

Rapid changes in virus conditions — for better or worse — can make many of the monthly reports that gauge employment, consumer spending, and production seem outdated and irrelevant by the time they are released. Consequently, economists and investors have been focusing on more timely data sources to monitor the economic impact of the pandemic throughout the nation. This information is reported every week, and in some cases every day, by government agencies or private companies with access to key business insights.

Here are some of the high-frequency indicators that may be helpful in evaluating the progress of the economic recovery.

Employment picture

A weekly report from the Department of Labor includes the number of new claims for unemployment insurance benefits under state programs filed by workers who recently lost their jobs, as well as the number of continuing claims filed by those who remain unemployed. This provides an early look at whether the labor market is improving or worsening on a state-by-state and national basis. For the week ending March 20, 2021, first-time claims for unemployment benefits fell to 684,000, the lowest level since before economic lockdowns began in mid-March of 2020. 2.

The ASA Staffing Index from the American Staffing Association tracks weekly changes in temporary and contract employment. Many employers rely on temporary help before hiring additional permanent employees, so staffing agency trends tend to lead nonfarm employment by three to six months. As of March 8-14, 2021, there were 11.2% more staffing jobs than there were one year earlier. 3

Consumer behavior

The proprietary Johnson Redbook Index captures consumer spending trends based on weekly data from a representative sample of thousands of large general merchandise and apparel retailers. In an encouraging sign, this key index improved 9.4% year-over-year on March 23, 2021. 4

The reservation app OpenTable has been monitoring the impact of COVID-19 on the hard-hit restaurant industry, providing data that doubles as an indicator of the “openness” of local economies around the world. Daily data shows changes in the number of people dining at restaurants compared with the same day of the same week in 2019. As of March 28, 2021, the weekly average number of U.S. seated diners was still down 29% from 2019, but had bounced back considerably from the last week in February, when the average was 40% below 2019. 5

Mobility and travel

Other technology companies rolled out tools designed to help public health officials and policymakers around the world monitor day-to-day mobility trends with data collected from smartphone apps. Google’s Community Mobility Reports show changes in visits to places like grocery stores, retail shops, and parks. Apple’s Mobility Trends Reports show changes in routing requests (since January 2019) for walking, driving, and public transportation trips, the latter of which have been slower to recover.6

The number of people who pass through U.S. airport checkpoints is posted daily by the Transportation Security Administration. On March 21, 2021, a spring-break surge caused the number of air travelers to rise above 1.5 million for the first time in about a year. Still, this total was far below the 2.2 million air travelers on the same Sunday in 2019. 7

The hotel occupancy rate (released weekly by STR) is another good indicator of the willingness of consumers and businesses to spend money on travel. U.S. hotel occupancy hit 58.9% in the week ending March 20, 2021, the highest level in a year. More importantly, the industry had recovered nearly 85% of comparable 2019 occupancy. 8

Real-time tracker

In May 2020, Harvard-based nonprofit Opportunity Insights, in partnership with several private-sector providers of high-frequency data, launched a real-time Economic Tracker as a free public service. Interactive charts show day-to-day changes in U.S. debit- and credit-card spending, small-business revenue, employment, online job postings, and time spent outside the home. In addition to nationwide statistics, disparities in progress can be broken down by income and industry, as well as by state or metro area.

Fed indexes

The Weekly Economic Index (WEI), which is published by the Federal Reserve Bank of New York, signals the state of the U.S. economy based on 10 different indicators of consumer behavior, the labor market, and production that are available daily or weekly. The WEI is scaled to the four-quarter GDP growth rate, which means the weekly result is the economic growth that could be expected if current activity continued for a year. For the week ending March 20, 2021, the WEI jumped to 4.14% from -0.33% the previous week. 9

In addition, the Federal Reserve Bank of Atlanta keeps a running estimate of GDP changes — GDPNow — that is updated based on a model that incorporates incoming economic data. On March 26, 2021, the growth estimate for the first quarter of 2021 was 4.7%. 10

These estimates are based on current conditions, are subject to change, and may not come to pass. Neither is an official forecast of the Federal Reserve. When investing, it’s generally wise to maintain a long-term approach based on your personal goals, time frame, and risk tolerance, rather than react too quickly to shifting economic dynamics

1) U.S. Bureau of Economic Analysis, 2021

2) U.S. Department of Labor, 2021

3) American Staffing Association, 2021

4) Investing.com, 2021

5) OpenTable, 2021

6) Apple Mobility Trends, 2021

7) Transportation Security Administration, 2021

8) STR, 2021

9-10) Federal Reserve, 2021

7
Feb

GameStop, Reddit, and Market Mania: What You Need to Know

Over the course of 11 trading days from January 13 to January 28, 2021, the stock of GameStop, a struggling brick-and-mortar video game retailer, skyrocketed by more than 2,200% — creating a mix of excitement and concern throughout the financial world, as well as among many people who pay little attention to the stock market.1 Other stocks of small, struggling companies made similar though less dramatic moves.

At the heart of this story are two very different sets of investors: (1) professional managers of multibillion-dollar hedge funds, who took large, risky positions betting that GameStop stock would drop in price; and (2) a small army of individual investors, connected through social news aggregator Reddit and other social media sites, who worked together to buy large numbers of shares in order to drive the stock price up.

As the stock price rose, fund managers were forced to buy more and more shares at ever-increasing prices to “cover their bets,” while individual investors continued to buy shares in hopes of continuing the momentum. The opposing forces created a feeding frenzy that sent the stock to dizzying heights far beyond the fundamental value of the company.2 The stock price peaked on January 28 and lost almost 90% of its peak value over the next five trading days.3

If you are confused, concerned, intrigued — or a combination of all three — here are answers to some questions you may have about the recent market volatility triggered by “meme” stocks, an Internet term for stocks heavily promoted through social media.

1. What is a hedge fund, and what were the hedge funds doing?

A hedge fund is an investment company that uses pooled funds to take an aggressive approach in an effort to outperform the market. These funds are typically open to a limited number of accredited investors and may require a high minimum investment.  Hedge funds use various high-risk strategies, including buying stock with borrowed money or borrowing stock to sell, called buying or borrowing on margin. This enables the fund to increase potential profits but also increases potential losses. (Individual investors can use these high-risk techniques, but the investor must meet certain financial requirements in order to establish a margin account and accept the increased risk.)

In this case, certain hedge funds borrowed shares of GameStop and other struggling companies on margin from a brokerage firm and sold the shares at the market price, with the expectation that the share prices would drop significantly by the time they had to return the shares to the lender. The funds  could then buy shares at the lower price, return the shares, and pocket the difference, minus fees and interest. When GameStop share prices began to rise quickly against expectations, the “short sellers” began to buy shares at market prices in order to protect against future losses. These purchases helped drive share prices even higher — supply and demand — which led to more purchases and even higher prices. This created a situation known as a     short squeeze.4

To understand the level of risk faced by the short sellers, consider this: An investor who owns shares of a company can lose no more than 100% of the investment, but there is essentially no limit to the potential losses for a short seller, because there is no limit to how high a stock price might go. This is why short sellers were willing to buy at ever-increasing prices, accepting large losses rather than risking even larger losses. In addition, they were forced to add additional funds and/or other securities to their accounts to meet margin requirements; investors must keep a certain percentage of the borrowed funds as collateral, and the higher the stock prices went, the more collateral was required in the margin accounts.5

2. What is Reddit, and what were the Reddit investors doing?

Reddit is an online community with more than a million forums called subreddits in which members share information on a particular topic. Members of a subreddit dedicated to investing coalesced around a strategy to buy GameStop stock in order to push the price up and squeeze the hedge funds. The potential for this strategy was first suggested on the forum in April 2020, but it exploded on Reddit and other social media sites in January 2021, after a change in the GameStop board of directors that encouraged bullish investors coupled with an announcement from a well-known short seller predicting that the stock price would quickly drop.6

While some investors genuinely believed that GameStop was undervalued, the movement developed into a crusade to beat the hedge funds in what amateur investors perceived to be a “game” of manipulating stock values, as well as a more pragmatic belief that there was money to be made by buying GameStop low and selling high. The fact that many young investors were gamers who felt an affinity for GameStop added to the sense of purpose.7

The strategy worked more powerfully than the amateur investors expected, and some who bought the stock in the early stages of the rally and sold when it was flying high earned large profits. However, those who joined the excitement later faced large losses as the stock plummeted. Once some hedge funds had accepted losses and begun to close their short positions, there was no longer demand for shares at inflated prices.8

3. Why did brokerage firms limit trading activity for certain stocks?

At various points during the peak trading activity, some brokerage firms stopped the trading of GameStop and other heavily shorted and heavily traded stocks. They also placed restrictions on certain stocks, limiting trading to very small lots and/or raising margin requirements. In a typical situation, an investor must maintain a 50% margin, meaning the investor can borrow shares or funds equal to the shares or funds in his or her account. Restrictions varied in response to the recent trading, but at least one brokerage firm raised margin requirements on certain stocks to 100% for long positions (purchasing stocks to hold) and 300% for short positions.9

The stoppages and restrictions elicited accusations of unfairness from investors and some members of Congress, who believed the brokerage firms were protecting the hedge funds. In fact, the moves were dictated in large part by clearinghouses that process trades from the brokers. These clearinghouses require that brokers keep a certain level of funding (collateral) on deposit in order to cover both sides of any given trade. As trading and values increased, clearinghouses asked for larger deposits. By halting and/or restricting trading of highly volatile stocks, brokers were able to reduce the required collateral, which enabled them to meet the new deposit requirements in a timely manner.10

The restrictions also helped protect investors from being overextended and suffering outsized losses amid extreme volatility. And to an extent, they protected the broader stock market. The New York Stock Exchange (NYSE) regularly suspends trading of individual stocks when price swings exceed certain limits. On February 2, when the price of GameStop was plunging, the NYSE suspended trading five times throughout the day, with each suspension lasting less than 12 minutes.  Although GameStop remained in the spotlight, more than 20 other stocks also had trading suspended throughout that day.11

4. What happens next?

It may take months or years before the full effects of the recent activity play out in the financial markets, but one clear takeaway is that social media, combined with accessible low-cost trading platforms, allows like-minded groups of retail investors to exert power that matches large-scale institutional investors. More than 10 million new brokerage accounts were opened in 2020, and many new investors are trading securities online and through smartphone apps.12

Some hedge fund managers have already stated that they will rethink their focus on short selling.13 And new services aimed at providing tools for professional investors to track investing discussions on social media platforms have quickly risen and may become a staple of investment research.14

Although the larger stock market remained resilient throughout the episode, extreme volatility is always a concern, and the Securities and Exchange Commission issued a statement saying, “The Commission is closely monitoring and evaluating the extreme price volatility…[which] has the potential to expose investors to rapid and severe losses and undermine market confidence. As always, the Commission will work to protect investors, to maintain fair, orderly, and efficient markets, and to facilitate capital formation.”15

What about GameStop and other companies involved in the volatility? The huge price swings had little or nothing to do with the actual value of the companies, and they will need to make fundamental business changes to address the underlying weakness that caused them to be targeted for short sales in the first place. The changes on the GameStop board that helped spark the rally, adding leaders with online expertise, may help the company compete in the marketplace, but that remains to be seen.16

As an investor, the lesson for you might be to tune out market mania over “hot stocks,” especially when there is little to back up the sudden interest other than speculation. The wisest course is often to build a portfolio that is appropriate for your risk tolerance, time frame, and personal situation and let your portfolio pursue growth over the long term. This strategy may not be as exciting as the wild ups and downs of stocks in the spotlight, but it’s more likely to help you reach your long-term goals.

The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Investments offering the potential for higher rates of return also involve higher risk.

Margin accounts can be very risky and are not appropriate for everyone. Before opening a margin account, you should fully understand that: you can lose more money than you have invested; you may have to deposit additional cash or securities in your account on short notice to cover market losses; you may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.

1, 3) Yahoo! Finance, for the period January 13, 2021, to February 4, 2021

2, 4–5) Kiplinger, January 30, 2021

6–7) Bloomberg, January 25, 2021

8) The New York Times, February 3, 2021

9) CNBC, January 28, 2021

10) The Wall Street Journal, January 29, 2021

11) New York Stock Exchange, 2021

12) The Wall Street Journal, December 30, 2020

13) Barron’s, January 29, 2021

14) MarketWatch, February 1, 2021

15) Securities and Exchange Commission, January 29, 2021

16) The New York Times, February 1, 2021