TODAY'S WORST INVESTMENT STRATEGY

I've Been Warning About This For Some Time. A common strategy for today's older investors is reaching for yield. Given the risk in the equity markets and less than 1% money market yields it is not surprising that older investors are trying to squeeze higher yields from their fixed income investments than is prudent in this market. Perhaps the worst strategy involves your friendly banker. In addition to the standard mix of certificates of deposits of varying maturities, your banker often has access to other products that offer higher yields. These are often inappropriate for older clients who don't want to take any risk and who might need access to the funds for future health care or other emergency needs. Here are a few strategies I have observed lately along with their implications.

1. Long Term Certificates of Deposit. I recently consulted with a client who bought a $150,000 certificate of deposit with a 2.5% yield. The maturity was five years. Although he has already received one year of benefits, he has four years to go at this yield. If he holds the CD to maturity, he may do considerably better than 1-year certificates or money market accounts; however, if rates go to 4% this year or next, he is stuck with 2.5% for the next 4 years. This isn't the worst case. This client is now faced with very high costs to provide health care for a spouse who has a chronic illness and requires round-the-clock care. Although the income from this and other investments was more than sufficient to fund ordinary income needs, it won't fund health care needs of the spouse. If it becomes necessary to terminate this CD prematurely, the penalty will undoubtedly exceed the interest collected. FDIC insurance provides piece of mind but it won't protect you if you need the money for catastrophic illness.

2. Special Structured CD's. This same client had a type of CD that I had never seen before. It came through a brokerage company owned by the same bank. At first glance, it appeared to be a standared $100,000, federally-insured 3 year CD with a rate of 4%. Doesn't sound too bad; however, there was another feature of which the investor was not aware. The second and third year interest rate of 4% would only be paid if the S&P 500 index was the same or higher than on the day of purchase. If lower, the interest rate for that particular year was zero. That's right the maximum rate was 4% but the minimum rate was zero. The penalty for early withdrawal was higher than a normal bank CD. This investment was entirely inappropriate for the client. Not only that, but the client had no recollection of being thoroughly advised of this adjustment feature.

3. Annuity Products. Although there is a use for annuity products in certain situations, many clients purchased these because of higher initial interest rates without regard to the other terms. For most clients over 70, annuities are inappropriate due to high surrender charges and low liquidity. The client in this example also had a$100,000 annuity. The terms of the annuity allowed it to be surrendered at no fee if the client or spouse went into a long-term care facility; however, since the client preferred home health care for the spouse, this didn't apply. Annuities are often popular with banks because of the high commissions involved but you need to make sure you know what you are aiming at before you pull the trigger.

Beware Your Friendly Banker. Bankers enjoy a higher degree of trust than other financial services personnel; however, they have conflicts of interest just like stockbrokers and some investment advisors. If your banker is recommending a financial product, look closely at whether he is making this recommendation for his benefit or yours.

MORE ON ENERGY

Double Hit For Gulf States. President Obama has been pressured to do something for the gulf states that have been devastated by the oil spill. Certainly, there is reason to believe that more could have been done by both BP and the Government. Obama is ever on the alert to find who's ass to kick and Secretary Salazar has has promised to "keep a boot on the neck" of BP to assure that they live up to their responsibility for clean up. In the meantime the administration has been reluctant to waive The Jones Act which forbids foreign governments from putting boats in the gulf to clean up the spill. The Saudis have developed technology which allows the oil on the surface to be vacuumed into boats and the water which accompanies the oil to be drained off the bottom and returned to the gulf. It's not complicated. As an old chemist I remember a laboratory apparatus called a separatory funnel which applies the same principal to separate water from organic liquids. While it would be difficult to use this method clean up all the oil from the spill, it could provide one more way to reduce the amount of oil that invades our shores. It is difficult to understand why we have not allowed foreign governments to assist us in this matter.

So what has the President done to help the environment? It's simple. He has banned all drilling in the gulf for six months and it is likely that this ban will be extended. The result is another hit for the economy of the gulf states. This will certainly prevent any environmental damage to the gulf but it will also eliminate thousands of jobs and deal another economic blow to the region. The next thing we know they will decide to eliminate auto fatalities by shutting down the nations highways.

It's Not As Easy As It Sounds. The President promised to shut down Guantanamo by January of last year. Its still open and its easy to understand why. One thing I disagree with the administration is their propensity to announce the elimination of something without a clear strategy for a replacement. Its the same way with their strategy to replace fossil fuels with "clean" energy despite the lack of an economically feasible replacement. In addition to the lack of economic feasibility, the environmental effects of many replacement strategies have not yet been fully evaluated. A recent article in Bloomberg discussed the merits of using diesel fuel from algae. Even though this works well from a carbon standpoint, it would take a network of ponds the size of the state of New Jersey to make enough diesel fuel to provide 6% of the world's needs. Consider the effect of that many stagnant ponds and the insect life that could breed there. I am all in favor of research in this area but we simply can't afford to stop producing conventional fuels until we have a viable substitute ready to go.

Natural Gas Is A Fossil Fuel. It burns cleaner than oil, is more efficient and produces less carbon dioxide per unit of energy obtained. We have a lot of it, particularly with the recent developments in ways to produce it from shale formations that stretch from Texas to New York. This could go a long way to produce enough low-cost energy, drastically reduce carbon dioxide emissions and lessen our dependence on foreign oil. Still, we have to develop ways to expand its use in transportation. One thing we can't forget is that the current production methods involve injecting 80,000 lbs of chemicals and copious quantities of water to "frack" the rock and get it to release the gas trapped within. In areas where they have begun recovering this gas there is much concern about contaminating the underground water supply. In some areas, water produced for domestic use has shown signs of methane and benzene contamination. Again, this points out the potential for environmental damage we haven't yet considered.

The Point To Emphasize. There is always the potential for environmental damage when we produce sufficient amounts of energy to run our economy. Our understanding of the risks of offshore drilling is probably greater than our understanding of the risks of some of the alternative energy production. I am all for stepping up our efforts to obtain renewable energy but it is insanity to stop production of conventional sources before viable alternatives are available.

Texas To Arizona And Back. I just completed a round trip via air. Now I know why I would often prefer to spend the two days driving each way. It has become increasingly difficult to get to the airport, navigate your way through security, find your gate, and get herded onto the airplane with a hundred other passengers. I spent $108 in parking and airport shuttle services just getting to the airport. I endured the indignity of a carry-on search because an operator saw something she didn't like in the x-ray of my bag. When the search was conducted there was another surprise, Omigawd, I was busted. A half used tube of toothpaste. You would have thought I was trying to smuggle an AK47 into the flight. When I mentioned to the lady searching my bag that I thought Arizona was the worst airport around in getting through security, she informed me that she was glad to hear that because it meant that they were more diligent in enforcing the rules. I knew the best policy at that point was to shut up and get outta there as soon as I could. I hope someday they catch someone trying to sneak through with a toothpaste tube filled with C-4 explosive. Then maybe all this hassle would have been worth it.

GENERATING RETIREMENT INCOME.

Are You Afraid of The Stock Market? If you are like most folks I know, you are afraid of the stock market. I must admit that those fears are well founded. Many retirees have lost a considerable portion of their nest egg despite having a diversified portfolio of stocks. It hasn't been easy for me either even though I have spent a considerable amount of time evaluating conservative investment strategies. As I have said many times before, the key to a successful retirement is cash flow. How much money is coming into your household as opposed to how much you have to spend to fund your lifestyle. I started this blog four years ago to emphasize that point. While I have periodically drifted to other subjects during that time, cash flow remains the central point of my investment strategy. One thing I have learned for certain: If I rely on bank insured deposits to provide my retirement income I will either be forced to severely curtail my lifestyle or go back to full time employment at the age of 72. In recent months I have extolled the virtues of cutting back to a more simple lifestyle; however, if I relied on insured deposits, my life would be much more simple than I would like.



How Do You Generate Income In This Environment? How about a "simulated CD?" If you have never heard of that one, don't feel alone. I know very few investors who use it and it isn't very well publicized. Here is how it works. Step one. Buy a portfolio of dividend producing stocks. Step 2. Sell a long term covered call against that position. By utilizing this strategy you can take advantage of the fact that once a company establishes a dividend policy, they take pride in maintaining that dividend. While this isn't a sure thing, it is usually much more dependable than trying to depend on buying low and selling high to fund your retirement. Step two. Sell a long-term, in the money call against that position. One sure thing in the market is that the premium portion of a call option will be zero at the time the option expires. Here is an example: AT&T is currently selling for $25.40 per share. The market will pay me $3.15 for an option to buy the stock from me at $22.5 on or before January 2011. The $3.15 is mine to keep as of the day I sell it, therefore, my net investment is $25.4 minus the $3.15 I received for the option or $22.25. If the market stays flat, I will sell for $22.5 for a return of 1.12%. I will also receive two dividends during that period of a total of $.84. This gives me a total return of 5.09% for 7 months or an annualized yield of 8.73%. What does this accomplish? It gives me a yield of 8 times what I could get on a CD of comparable maturity and downside protection of 12.73%. While this isn't a huge return, as stock market investments go, it competes very well with a CD on a risk adjusted basis.



You Don't Have To Use Dividend Paying Stocks. As of today's date, I could buy Devon Energy at $69.9 per share. If I sell the $60 January 2011 call I could put $13.35 in my pocket leaving me a net cost of $56.55 per share. Assuming the stock is above $60 in January, my return is 6.1% for 7 months or an annualized yield of 10.46%. Again, I receive a return of 10 times the CD rate and $13.55 downside protection or 19.6%. On a risk adjusted basis, this is very attractive. To tell the truth, I am not all that sure the government can stand by their insurance on those FDIC guarantees either. Do I think you should employ a strategy like this exclusively? Of course not but its not a bad strategy for some of that spare cash you have laying around in your investment account.

Politics Rears Its Ugly Head. When George W. was president, I grew tired of hearing people criticize him. Not that some of it wasn't valid. It was the personal attacks I didn't like. At that time I made up my mind that I was not going to do the same thing when the new president came into office; however, this doesn't mean I can't be critical of the policies endorsed by the party in power. So far, I find it difficult to find much good to say about the polices of this administration. The most difficult to accept are energy policies. The cold hard facts tell me that we can't afford to move away from fossil fuels at this time. We simply can't afford the "Cap and Trade" fiasco that congress is trying to pass. One of the least acceptable provisions would require that potential home sellers to obtain an "energy audit" that assures the home will meet certain efficiency standards at the time of sale. Those who don't meet those standards will have to remedy the situation before the home can be sold. With the current malaise in the housing market this will place an additional burden on already overburdened sellers. Our freedoms continue to disappear as the government decides they know more about how to run our lives than we do. It's time to put a stop to it.

DISASTER IN THE GULF

Can We Quit Drilling Off Shore? Many so-called environmentalists think we can and should. Those pictures of oil-soaked birds and dead sea turtles bother me as much as the next person; however, my answer is that we can't and we shouldn't. As much as I love the gulf coast (after all, I live here), I am a practical man and I know we have to use offshore oil to keep from giving everything we earn to OPEC. To those who want to drastically cut back on domestic oil production my comment is: "You start walking first."



Can We Learn Anything From The Disaster? I think we can. Perhaps the most important is the fact that, we can't expect the government to fix everything. Government agencies had the authority to monitor BP very closely. Still, they couldn't keep the rig from exploding. Just a few days prior to the explosion, it was announced that BP was one of three finalists for the Dept of Interior's safety award. If BP could have prevented the public relations disaster that was this explosion, they surely would have. Despite the fact that the EPA, OSHA, DOE, and DOI with their multitudes of employees had the authority to make inspections and halt production, production proceeded and we have a major problem. Both BP and the government have an arsenal of resources to deal with all the oil washing up on shore but the cleanup has barely begun. Hurricanes, tornadoes, earthquakes, and oil rig explosions will happen from time to time and, if you wait for someone, like the government or the big corporations to save you, you are bound to be disappointed. Our founding fathers came here 400 years or so ago and there was no one to save them. We need to follow their example and provide for ourselves.



What Does This Mean For Our Economy? Lots of fish, shrimp, and birds will die in the gulf. Tourists will stay away from the beaches in droves. Its going to hurt the economy in this region for some time. Its a problem we didn't need at a time when we are discovering that many of us have been living beyond our means and can no longer afford to continue. Companies that produce drilling rigs and have concentrated exploration and production efforts in the gulf will have to stop work or develop more elaborate techniques to manage the risk of offshore production. Still, we will be drilling offshore again because we can't afford not to. Nature produces bacteria that will destroy the spilled oil that escapes man's efforts to remove it.

How Can We Protect Ourselves? Live frugally, invest conservatively, and keep a cash reserve for emergencies and to take advantage of opportunities that will undoubtedly arise in the future. If life hands you lemons, get some tequila and salt and give me a call.