This week, I want to discuss how the traditional thinking surrounding an investment portfolio looks like it is about to be turned on its head – largely due to the irrationality of many market participants and outright ludicrous central bank policy.
I’ll begin with a little investing primer, assuming you know nothing about traditional investment strategy.
Conventionally, the thinking when it came to managing an investment portfolio had an investor looking to allocate assets between stocks and bonds. One only needs to look at the investment allocation options in most 401(k) plans to see this is the case.
If you have a 401(k) plan through your employer, take a look at your options, they probably break down into three basic categories: stocks, bonds, and cash.
Cash assets are money market accounts or perhaps a stable value fund. Stock assets are typically in the form of mutual funds and can have many different names. Small-cap, mid-cap, large-cap, emerging market, Pacific Rim, European, international and index funds are all stock funds. Any fund with the word ‘equity’ in the name is a stock fund.
Bond assets can also take many forms. A bond, if you’re totally unfamiliar with investing is simply a loan made to a company or a government. If a fund has the words ‘fixed income’ in its name, it is a bond fund.
Cash assets typically pay a rate of interest on deposited funds although today the level of interest paid is meager.
Stock funds may pay a dividend; however, most of the returns in stock funds come from shares that are appreciating due to the shares of stock owned by the fund increasing in value. A rising stock market means rising stock funds.
Bonds pay interest. And, as interest rates decline, bonds appreciate in value. The reason is simple. If an investor purchases a bond that is paying interest of 4% and a few months later market interest rates have declined to 3%, the investor holding the bond paying 4% interest would be able to sell her bond for a premium.
As interest rates decline, bonds appreciate and pay interest. If interest rates rise, bonds decline in value while continuing to pay interest.
Here is where traditional thinking is about to let investors down in my view.
From a time perspective, we are in the longest stock bull market in history. And, there are signs the market may be getting tired. At very best, this stock bull market is stale.
Looking at the bond market, there is only one rational conclusion at which one can arrive – it’s ridiculously overvalued and is in a massive bubble.
Consider this from Bill Blain this past week (emphasis added) (Source: https://www.zerohedge.com/economics/blain-what-i-see-today-scares-st-out-me):
I’ve spent most of my career in the fixed-income markets. What I see today scares the s*** out of me.
We are looking at 2% yields on the 30-year US T-Bond. That’s the highest bond yield in the whole developed world sovereign bond market! And the market thinks it’s a bargain because US rates are inevitable going to zero and beyond! That is not good. It really is not good. It is not normal. It means something is very very wrong.
Yet investors can’t get enough of it… delicious, yummy sub-zero percent yielding bonds… September was a record month for corporate new issuance – more than $300 bln of issuance. (When I started in the market back in the 1980s, a record month would be a couple of billion!) We’ve now got governments around the globe taking about fiscal reflation and borrowing more – why not? Yields are so low a few trillion more in debt can’t hurt… can it? Of course not.. fill yer boots.
As bond yields continue to fall, the investment banks are churning out new deals as fast as they can type out the term sheets. It’s even more manic in High Yield. Investment banks make higher fees from junk issues – so guess what.. the market is flooding with paper. And investors are hoovering them up – they just love the yield (ie positive), the investment bank analysts are telling them to buy, and they figure that because there is a global recession coming and Central Banks will ease rates – then why not ride the next leg of the Great Bond Rally?
Whoa. Stop. Think. There is a little word…. Risk.
Remember Blain’s Market Mantra Number 1: “The Market has but one objective – the inflict the maximum amount of pain on the maximum number of participants.”
If there is a global recession, what happens to bonds in a recession? Sovereign bonds and most investment-grade bonds tighten. Tick. (Well, they would tighten if they weren’t stupidly tight already..) High Yield Issuers go bust. Big X.
One of my European chums was amazed a BB junk French laundry firm he’s never heard of, Elis, was able to raise 5-year debt at 1% last week. This would be the same company no one had previously ever heard of that caused some eyebrow raising earlier this year when it launched a covenant-lite junk bond. This time around no one even blinked. The reality is issuers are getting deals done with less investor protections and lower yields than ever.
A bubble never seems like a bubble until it bursts and, as Blain hypothesizes, inflicts the maximum amount of pain on the maximum number of (market) participants.
Since 1971, when the link between the US Dollar and gold was eliminated, there have been a series of boom and bust cycles with each bust inflicting more damage on investors than the prior one.
From my perspective, the next bust cycle has the potential to be the mother of all busts. What happens if stocks correct like in 2001 and in 2008, falling by 50% or more and, at the same time, the bond bubble bursts and yields move up?
The typical 401(k) investor or IRA investor sees his dreams of a comfortable, secure, stress-free retirement evaporate.
I believe there is a very high probability that’s where we are headed.
Putting a plan in place to address this now, before the bust, may be the only way for many aspiring retirees to hang on to their dream of a comfortable retirement and make it a reality.
So, what should you consider?
It depends on your own, individual situation. You should always seek the advice and counsel of a reputable professional with a solid knowledge of economic cycles.
That said, during The Great Depression the number one, best performing asset was an individual corporate bond.
While owning bond funds has a high degree of risk as I’ve discussed, holding individual corporate bonds to maturity allows an investor to know her annualized return in advance for each year the bond is held provided the company that issued the bond is solvent.
Corporate bonds are backed or ‘collateralized’ by the real, tangible assets of the company that issues them.
The risk in holding highly rated corporate bonds is that the central bank policymakers not only continue to reduce interest rates but also print money as they have over the past decade.
There is currently a grand experiment taking place. Policymakers are trying to determine how far below zero yields can actually fall. My take is that on a global basis, yields can continue to fall for a little while yet, but the bottom can’t be far away.
When the bottom hits and bond investors panic, that may very well be the catalyst that drives stocks and bonds lower.
At that point, the policy response may be more money creation. Since that is a real possibility, owning some tangible assets like precious metals along with highly rated corporate bonds might be a good idea.