Where to invest when both primary asset classes are at risk?
Today’s market conditions raise interesting questions. On one hand, stocks seem expensive and the underlying environment seems uncertain. When stock returns are uncertain (or more uncertain than normal), many investors shift to bonds. But, with the expectation of rising interest rates, is now a good time to invest in fixed income? I regularly hear versions of this question, so let’s consider our choices.
Stocks perform well when market participants have faith in the economy’s future. The idea behind investing in stocks is straight forward…if the market and economy grow, companies should earn more. Higher earnings (all else equal) should result in higher stock prices. I purposely use the word should multiple times. If only the markets acted rationally ALL the time, this process would be simple. But, here is a news flash…markets don’t always act rationally. This is a bigger problem in the short term, the market tends to get it right when given a longer time horizon.
When considering a rationale valuation of a stock, there are three key components; dividend yield, earnings growth and the valuation of future earnings (Price/Earnings multiple). Current dividend yield is easily measured. An increase in dividend should increase the valuation of the stock overall. Note…stock prices technically decrease by the amount of the dividend when “earned” (a topic for another day).
Past earnings are known and companies provide “guidance” for future earnings. We should only see a rise (or fall) by the change in actual earnings or guidance. With the first two components known, the key factor when considering stock prices is the change in what investors are willing to pay for earnings (known and expected). This is the emotional component.
Now, let’s consider bonds. A bond’s value begins with a risk-free rate of return. This is the return expected with no risk. The most common rate used is the yield on a three-month US Treasury Bill, not perfect, but a good starting point. From here, investors add a premium for any risks associated with the individual bond. Primary considerations include: inflation, liquidity, default, and maturity. As each risk changes, so will the valuation of the bond.
Given our desire to use bonds as a tool to lower the overall volatility of the portfolio, we can (for the most part) ignore liquidity and default risk…at least for today. Students of the markets would be quick to remind me that liquidity was a concern in 2008/2009 for even the “safest” bonds. Hopefully, we won’t be addressing that scenario again in the near term. Addressing what is the “right” premium for each risk factor is the emotional component of bond investing.
As we consider the current state of stocks, the greatest driver of valuations is relatively high earnings per share and a high multiple being paid for future earnings (PE ratio). The current dividend yield is below historical mean which isn’t surprising given current interest rate levels.
The earnings per share calculation may be skewed given aggressive buy backs of shares by many companies over the past few years. Remember, every ratio has two components; in this case the ratio includes the numerator (earnings) and denominator (shares outstanding). Stock buybacks decrease the denominator. In other words, the ratio would increase with no change in actual earnings when the denominator decreases.
Prior to Trump’s victory, the primary catalyst for growth was a slow, steady increase in economic conditions and a very accommodative Fed. With rates at zero for most of the past 8 years, the cost of borrowing money was artificially low. With limited yield, market participants shifted investments from safe to risky assets. You may hear the term “risk on.”
With Trump’s victory came an increased confidence. His promise of lower taxes, more jobs, and less regulation resulted in new market highs. This is where we sit today.
When considering bonds, we have been working with near historic low rates…a low risk-free starting point. Until recently, there has been little concern of a significant inflation increase (at least in the short-term). This creates limited inflation premium. The current upward sloping yield curve reveals markets expect higher rates in the future (maturity risk premium). Without a surprise to either the inflation assumption or future rate expectations, the current curve is our best measurement of future rates.
The Fed will be hard pressed to keep rates low as the markets and economy(?) gain strength. The odds of a rate increase at March’s Fed meeting is almost guaranteed (employment number this Friday is the only potential unknown). This is where we sit today.
Answer the question…
But, we are not worried about where we sit today. We already know the answer to that question. What we want to know is what to do next. To answer that question, let’s consider the potential changes to today’s picture and consider how each would likely affect stocks and bonds.
The best case for continued stock appreciation is fulfillment of current promises. If Trump (and Congress) creates new jobs (good paying ones), lowers taxes and decrease costs of services/goods (lower regulation) we would likely get a continued rise in stock prices. In this scenario, higher employment broadens the tax pool which means we could pay lower taxes individually while maintaining or increasing the nation’s income. In this scenario, current high PE multiples may be justified as earnings increase. In this scenario, the confidence and growth allow the Fed to raise rates without a significant impact to markets.
In a scenario where promises are fulfilled, we would expect the Fed to raise rates. The increased rates are expected given the current yield curve. If rate increases were steady and expected (guidance), there should be limited affect in a well-diversified bond portfolio.
Unfulfilled or delayed promises
A bad case for stocks is the failure to implement campaign promises or a significant delay in doing so. The markets want to believe that current promises will be filled. In both scenarios where Trump spoke of growth in a “presidential manner” (election night and this past Tuesday), the markets reacted favorably and quickly.
If the confidence is lost or take too long to implement, we may find ourselves looking at the scenario many experts projected before the election (if Trump was elected) …a significant pullback in the markets and a potential recession.
While this scenario wouldn’t be the best outcome from an economic standpoint, it would likely benefit bond portfolios. A slower (or decrease) rise of interest rate increases would benefit bonds (especially if higher rates were expected). Additionally, a shift to “risk off” would also benefit bond holders as stock investors sought the safety of bonds.
As mentioned in a previous post, the difference between the “pain” of a bond bear market and a stock bear market are significant. You are likely aware of stock returns in the Great Recession. Stocks lost approximately 50% of their value. You may not be aware of the impact of a Bond Bear Market. In the period between July 1979 and February 1980, an intermediate-term bond index lost 8.89%. While arguably a significant loss for a “safe” asset class, it isn’t the same as losing half of a portfolio. It is important to remember the magnitude of loss when considering the difference between a bond bear market and a stock bear market.
Emotions and points of reference
As we consider points of reference, I am reminded why it is important to maintain a point of reference in all areas of life. If you have been a regular reader, you know Stephanie is a good kid and hopefully, I am a good dad. But, there are days when one or both of us lose our point of reference and emotions affect our choices.
The most recent happened during Tech Week. Steph lost her focus (continuously) and I was tired. After misplacing multiple costume pieces, I finally lost it. “You need to start taking better care of your props and costumes. I can’t always rebuy or fix the losses caused by your lack of attention.” Did I mention that Steph is usually a really good kid? I often remind myself that if this is the worst issue while raising her…I have it pretty good.
As the week ended and the play began, I saw multiple emails from parents asking for help looking for missing props and costumes. Hmm…maybe it isn’t Stephanie. Perhaps it is part of being a 10-year old. On most days, I remember that. When I am tired; sometimes I forget.
Why share this? Because emotions matter. When you are frustrated by the theme, you might be tempted to forget all that came before it. You might lose focus of the big picture. You might be human and react without taking the time needed to fully appreciate the situation. Yes…it happens to all of us.
I hope one of the lessons Stephanie learns from me (and me from her) is understanding how emotions impact decisions. She may be even better at it than me. She will ask if I am tired or hungry when grumpy. At that moment, it rarely helps. A few minutes later…I often realize she is right and we address the situation with a fresh set of eyes and fewer emotions…and go back to having fun…
I hung out with Steph and her friend before her play on Friday. Put two 10-year old girls together in a mall and you regain the proper perspective of where a 10-year old’s head is at…it is about having fun. This is where it should be. Yes, she will frustrate me when she fails to pay attention AGAIN, but hopefully, by writing about it, I will consider my current emotions and center on the proper point of reference.
Emotions and the Final Answer
The original question was what to do when both asset classes (stocks and bonds) appear to have a higher than normal amount of risk. If we take emotions out of the decision and focus on the point of reference, we’ll come to an informed decision.
For me, the current decision is to maintain a diversified portfolio. That means a diversified stock portfolio that holds more than just US stocks. It also means holding a diversified bond portfolio. The diversification in the bond allocation may be more important than the diversification in the stock portfolio given today’s environment.
Although stock asset classes differ in returns and risk, when things go bad, stock correlations often go to one. This means they all fall together. When this happens, the media questions the benefit of diversification. When this happens again, I will address it. For now, diversification provides investment in asset classes with lower valuations (and expectations), which is my primary concern of US stocks.
A diversified bond portfolio creates a different story given today’s market conditions. As we invest in short term bonds, we lower our maturity risk (the biggest factor when considering a rise in interest rates).
We also add an inflation protected bond allocation. With growth (and assumed rising rates), we would assume an increase in inflation. This asset class helps offset the inflation premium risk.
Finally, we invest in intermediate term bonds. This provides a higher yield than short-term bonds. The current yield curve is the market’s most informed “guess” of where rates will be in the future. We expect rates to go higher. So, we accept a little more risk with the goal of a little higher return.
We aren’t perfect
My biggest concern is that markets have priced perfection into the market. It has been awhile since the markets felt a significant and prolonged pullback (we are quickly approaching an 8-year bull market – second longest in history). How will markets react if perfection isn’t achieved?
The answer…I recommend maintaining a diversified portfolio with a slight shift towards safety. If both asset classes are “risky”, we know from history, the pain from one is less than the other. Finally, as the market focuses on perfection, the market has also become complacent. More on that next week…