LEAPs, Liability Matching, Capital Losses

1. Reader Question

Schwab's Liz Ann Sonders says that US equity market is entering the fourth phase of bull market, where the returns could be rapid and sharp. I've been long SPY since March 2009 lows, so have done well. Should I lock my gains and use LEAP options to play any remaining upside in SPY,while controlling my drawdown risk? Feels like a much better risk reward going forward, now that VIX is low and options prices are relatively low.

My Reply

Liz Ann Sonders has made a nice series of market calls in the past seven years or so but I'm not yet willing to conclude that she is the exception to the very long line of gurus and experts who were right until they weren't (John Hussman might be the most tragic example of that). I would ignore her predictions -- at least until she has another decade or two of correct calls.

Stocks are definitely not bargain-priced but they are still priced for maybe 3-4% real return over the next couple of decades. This is based on combination of my general approach of expecting the future to be a bit less generous than the past, P/E10 of 23-24, and the reversion-to-mean hypothesis. Not particularly great but better than bonds and, in absence of attractively-priced alternatives, not nearly enough for me to drop out of the market entirely.

LEAPs are a lot more reasonable than dropping out of the market but you would be paying around 10% for at-the-money 3-year LEAPs and then foregoing another 6% or thereabout in dividends over those 3 years. So you are in a 16% hole to start with. If the market were to drop by that much it would get pretty close to historically average P/E10 (after adjusting for buybacks versus dividends, see http://www.longtermreturns.com/2012/03/dividend-and-buybacks-cape-impact.html). Not that it can't get to much cheaper than average, but it's kind of optimistic (from a bear point of view) to expect a much bigger drop.

If all this takes place in a taxable account, then you're also on hook for taxes which would ruin everything if you have been long SPY since March 2009. You'd be sitting on close to 100% in long-term capital gains and would fork over 15% or thereabouts to Uncle Sam if you realize them. That would put you 30+% in the hole right off the bat which should be more than enough to convince you to drop the whole idea.

Assuming that this is in an IRA, we then calculate how much yield you might get out of the cash you freed up... Here the most you can realistically hope for is maybe 5% in those 3 years -- unless you are willing to take a risk on long-term bonds which would be taking a risk on one relatively overpriced asset while avoiding another.

Adding it all up, with the LEAPs approach you'd be paying around 10-12% in insurance against a bear market in the next 3 years (after allowing for income from freed up cash). Probably not a ridiculous strategy but I'd take my chances staying in the market and waiting for a bit more of a "bubble" before starting to pay for downside protection. And, again, I definitely would not even consider this in a taxable account.



2. Reader Question

I am a 40yr old, married with kids. I have $250,000 in short-term capital losses from many years ago. Is there any good way to offset these losses? I really enjoy your website and have used much of your advice. Thank you.

My Reply

Unfortunately there is not a whole lot you can do to covert these losses into tax credits quickly. You can deduct up to $3,000 in capital losses (short-term or long-term) annually and hopefully that amount will eventually go up, but even if it does I'm sure waiting 50+ years is not what you had in mind as far as making use of these losses. Beyond that the only way you can use these losses is to offset capital gains. The way the tax code is written is a little convoluted, but in the end you can use these short-term losses to offset either (or both) long- or short-term capital gains -- after first using up any long-term capital losses you might also have to offset long-term capital gains. The most likely scenario where this makes sense is when you sell your investments to finance living expenses.

But it could also make sense when you don't need the money, but wish to change your investments. Perhaps because you have bought something that now you realize isn't a good long-term holding, but that still has capital gains. An example might be buying an actively-managed US stock fund in, say, 2010. Any such investment should be enjoying significant unrealized capital gains now -- not because of its manager's skill but because the entire market rose nicely since 2010. You can sell this fund and use your capital losses to offset the gains, while immediately switching into a more desirable (meaning low-cost) US stock index fund.

Or maybe you just lucked into something that went up rapidly and no longer represents a desirable holding at current price. For example you might have bought long-term bonds in early 2011. If that is the case you are likely sitting on 15-20+% gains now and those bonds no longer represent nearly the value they did in 2011. You can sell them and lock in the profits without paying taxes by using your capital losses to offset the gains.



3. Reader Question

What are your thoughts on William Bernstein's Liability Matching Portfolio concept? The idea is that in retirement you should have a portfolio of safe investments to cover your basic cash flows (liabilities). Only once those cash flows are covered can you then consider investments with more risk. This concept comes from a recent ebook that can be found at Amazon, "The Ages of the Investor: A Critical Look at Life-cycle Investing." Applying this concept to someone who has considerable investment assets and requires less than 1% to maintain a lifestyle, do the guidelines for reducing equity exposure in retirement still make sense in this case? Rather than maintain a constant allocation between stocks and bonds, perhaps it might be better to allow an allocation to equities drift upward since the person is now really investing for his heirs assuming the liability matching portfolio remains intact. Finally, follow Benjamin Graham's advice to limit oneself to a maximum of 75% equities. This would be an approach to maximize a portfolio value over a 30 to 40 year timeframe, perhaps longer if trusts become involved.

My Reply

I haven't read that specific e-book but am loosely familiar with the concept of liability matching. I think it's an interesting approach in theory but I am a bit skeptical about its practical application:

• It's very hard (impossible?) to project even approximate living expenses decades in advance. There will be a big fudge factor involved, intentional or not. More realistic is to see how life goes and adjust living expenses to what it delivers.
• Committing oneself to matching even most basic retirement liabilities with safe investments before introducing any risky ones requires prodigious amounts of savings and makes it hard to retire early. Today's low interest rates magnify this problem.
• Unexpected inflation can mess up any liability matching plan that uses nominal bonds/CDs. And one's personal inflation may end up quite different than CPI-U used by TIPS/I-Bonds. This is a variation on my first objection, I suppose.
• A 100% "safe"-asset portfolio has historically been more volatile than one that has a bit (20-30%) in stocks. My hunch is that the same will be true in the future. I would take reasonable expectation of lower volatility and higher returns over the dogma of liability matching with safe investments only.

But if you are able and willing to stick to liability matching approach, then it's certainly a reasonable approach. Being a high earner (and/or low spender) helps a lot. Frankly, pretty much any strategy you can imagine will work just fine if your portfolio size is over 100 times annual living expenses. I would probably prefer something like the Permanent Portfolio in such a scenario. 

I can't think of any reason to conclude that liability matching or age in bonds or constant ratio of stocks/bonds or any other such strategy is clearly preferable to all others. And anyway, it's a moot point if you spend less than 1% of your net worth annually -- any half-way reasonable approach will suffice.

4. Reader Question

In order to maintain a 50-50 portfolio in Vanguard while using PedFed to eke out a little higher rate of return for fixed-income using a ladder of CD's, would it be a reasonable strategy to keep a certain amount (10-25%?) in Vanguard's Total Bond Market Index and/or Short-Term Index for purposes of reblancing? And thank you, having discovered your blog via Bogleheads has been a great help in helping me decide what to do with my current fixed income allocation of 50-50 TBM & TIPS. I'm still confused but if I understand correctly maintaining that ratio wouldn't be a disaster over a 30 year period, though it seems it might be good to either lighten up on TIPS or build a CD ladder in lieu of them.

My Reply

Glad you found my blog useful. If you wish to hold bonds for rebalancing you could certainly continue to do so and only allocate a portion of your fixed-income portfolio to CDs. If your portfolio is relatively small and you are in accumulation stage you could also "rebalance" by simply directing all your new contributions towards equities if and when we hit the next bear market. But keeping some bonds for rebalancing is perfectly reasonable as well.

And yes, it's very unlikely your 50-50 TBM-TIPS will be any kind of disaster -- at least not relative to other fixed income alternatives. The biggest worry would be that we are now at the same point in the fixed income world as we were in early 1940s and are starting at decades and decades of sub-inflation returns (remember that today's TIPS such as VIPSX as priced to lag inflation). But in that scenario no bond will be safe and your 50-50 TBM-TIPS will likely as lousy as any other bond portfolio you might hold. Whether we are due for something like that is not something anyone can predict. It's a possibility to be aware of but I would not plan my investments around it because it is just that: a possibility but in no way a certainty.

One thing you can do to ameliorate the damage of such a scenario is load up on I-Bonds. They are easily better than any TIPS today (maybe not 30-years, but that's comparing apples and oranges). I would put I-Bonds above even CDs as best deal going in fixed income space. Unfortunately the $10,000 per person annual limit puts a damper on their impact on large portfolios. And they are only available in taxable accounts which might force you to pass on them in order to be able to fund an IRA. But if you have some taxable accounts at all, you should think whether you can reshuffle your holdings to allocate taxable space to I-Bonds and tax-sheltered space to stocks and maybe some other bonds.



5. Reader Question

Hello, I just started to read your blog, great by the way!, and have some very simple questions. Most of your questions are way over my head and may be too simple for this blog. The question I wan to ask is… is it true that in order to have good credit it’s good to have some debt? I heard that owing student loans, at a very low rate, and a few credit cards with low interest and not maxed out is good to keep your credit score up, as long as you pay them and have a low %? Thank you. Keep up the great work!

My Reply

Glad you like my blog. Your question is a bit off from topics I usually cover, but I think I know the basics of what you are asking... Primary things that will improve your credit score are, of course, paying your debt on time, long credit history, existing lines of credit, limited number of attempts to obtain credit, and investment-like debt. Investment-like debt means debt that has potential to increase your net worth, such as a mortgage (a house is an asset that will grow in value over time) or student loans (which, hopefully, allow you to make more money over time thanks to your education).

Things that would detract from your credit score are, obviously, non-payment or late payment of any of the debt, purely consumptive debt (such as car loans or store cards), lots of attempts to open new credit cards, or high utilization of lines of credit. I am not sure but I don't think you are penalized for paying off your credit cards on time in any way -- in fact that would be a sign of responsible consumer. So I would not intentionally keep balances on my credit cards and pay interest just to get a higher credit score.