Traditionally, one of the safest investments strategies for folks close to or in retirement was a 60% / 40% stock bond ratio, invested in the well-run, low cost or no-load mutual funds. This article explains why “This Time It Really Is Different”, and investors pursuing that approach today may suffer profound regret.
But first check out this graph, showing how well a balanced approach has done:
As this shows, over the last decade investors in Vanguard’s VWELX or VWINX fund would have gained more than investing in the S&P 500 (up 96% over the period), 150% and 131% respectively. Equally important, they would have done so with far less drawdowns in the crash of 2008 (24% and 48% vs S&P’S 78% drop).
In fact, as I’ve shown in a previous article in , Seeking AlpSeeking Alpha’s financial blogh, this outperformance of the 40/60 balanced approach holds well going back over another decade.
But today, I am convinced, the logic behind those patterns no longer holds.
As a consequence, both stocks and bonds will drop in sequence, rather than acting as counterbalances. This means that your 60% stock holdings could bring you a huge amount of pain, while your bonds only bring you a large amount of pain. Either way, the next effect is very painful.
I liken the moment we find ourselves that of the real estate market in mid 2006. The signs of a crash were imminent, and many smart people were warning of ludicrous values, dangerous mortgages, shady mortgage practices, and a warped property to income ratios. I remember at that time warning a friend of mine not to engage in his fourth house flipping in 10 years. Unfortunately for him, he ignored my advice, only to be later faced with a $1 million mortgage on a $500,000 equity value and monthly payments double his income.
Back in 2006, I could not tell him for sure when a crash would happen, and what event would trigger it. I just recognized that values were not sustainable. In fact my timing was a bit off. Another year passed before housing prices lost 70% of their value. As you can see in the graph of Real Estate Investment Trust prices below, real estate values climbed another 20% over the next year.
Was I wrong to warn him off his investment? Obviously not. Many small fortunes were built on the precept of “selling a bit too soon”, and far more were lost on the premise of “following the wisdom of the crowd”.
So now let’s look a today’s situation. Six factors show that these stock market valuations are not sustainable, and that a significant correction must follow soon:
- Shiller’s Historical Price Ratio . P/E ratios, fueled by the FED’s money printing, are at levels usually found just before market crashes.
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The last time Shiller PE ratios were above 27 was in 1929, 2000 and 2008. The S&P 500 subsequently crashed by 90%, 33% and 47% over the next 18 months. (Readers are encouraged to visit the gurufocus site for an explanation of Shiller’s research and findings.)
- Corporations are propping up stocks by using “quasi-free” money by borrowing in corporate markets.
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In the past, when borrowing levels got so high, market crashes often followed. Will this time be different?
- One of the biggest areas of concern, is that corporations are not making the capital investments that result in real long term growth.
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Even the economists at the FED – not exactly innocent of a role in the decline of capital goods spending – recognize the danger in this steep decline. They attribute 80 percent of a country’s future growth to the investment in capital goods, as a recent FED study demonstrates.
- Corporate profits have declined over the last four quarters, yet the stock market is making higher highs. Bubble anyone?
- Productivity has ground to a halt.
- The money supply (M2) has been increasing by 6-7% a year, which has always ended in the past in inflation.
OK, so maybe you believe that a stock market correction is possible, and even probable. But why does that imply that both stocks and bonds will decline, and that the traditional haven of bonds will not hold?
The answer is: because overall bonds are overvalued. Today, if you invest in any company that can be reasonably assured of avoiding bankruptcy even in a severe market downturn, you are paid around a miserly 2% over 10 years. If long term interest rates regain even half the value by which they have dropped in the last 6 years, an investor buying those bonds would see values decline by far more than their coupon payments. If instead of selling at a loss, they hold them to term to obtain a return of capital, on a net basis they are likely to be a loser to inflation.
If, on the other hand, you go for higher interest rates to protect from possible future inflation and interest rate hikes, you are now faced with greatly increased risks of default and total loss of principal.
But wait, you say, there is no inflation anywhere on the horizon! Watch out, says Federal Reserve Alan Greenspan. If he is right, we may get both a drop in the markets AND higher inflation, and consequently higher interest rates. In a recent interview with Bloomberg News, Greenspan commented: “I know if you look at human history, there are times and times again where we thought that there was no inflation and everything was just going fine. And I just basically say, wait. This is not the way this thing ordinarily comes up. I don’t know. I cannot say I see it on the horizon. In fact, commodity prices are soggy. The oil prices has had a terrific impact on global inflation. It’s not about to emerge quickly, but I would not be surprised to see the next unexpected move to be on the inflation side. You don’t have inflation now. And you don’t have it until it happens.”
There is one scenario that is good for bonds, and in this author’s opinion is more likely to happen. That is a severe and prolonged recession affecting most of the global economy. In that case the central banks of the world may decide to keep interest rates low and possibly even go negative, as Europe and Japan have already done.
A strong corporate or government bond bought today with a duration of 10 years would see appreciation of 10% , 20% and even 30% in the event of a decline from 2% levels to levels of negative 1% and negative 2%. Unfortunately, such an outcome is not only a likely result of a severe drop in stock markets and real returns worldwide, but also may even exacerbate those conditions – due to its negative psychological impact on investor confidence and disruptive impact on careful capital allocation.
So the small gain you might see in the 40% of your portfolio held in bonds could be more than swamped by the disruption in your stock portfolio.
It is these dismal future prospects that have led people Warren Buffett to project that future decades will not bring the 9% averages a long term investor could aspire to, but rather much lower averages in the 2-4% range.
This view is shared by Bill Gross, one of the most successful bond managers of the last 20 years and current manager of the $1.5 billion Janus Global Unconstrained Bond Fund: “I don’t like bonds; I don’t like most stocks; I don’t like private equity,” Gross, wrote in his recent monthly investment outlook Wednesday.”
An overall mixed portfolio that could yield 8% to 10% on average in the past is more likely to product 2% to 4% in the future, with a lot of short term pain along the way.
Just so that we don’t end up on a completely pessimistic note, there are strategies than can outperform even in these confusing and distressed times. Conservative investors may want to look at this post while investors able to tolerate more volatility would want to look at a mean-reversion algorithmic approach, as described in a previous post. Here’s how that has performed in historic backtesting:
Same Bumps, But A Lot More Ride
- Long Short Mean Reversion
- Performance-based limited selection
- Less conservative hedging allocation
- Mean reversion methodology
- Goes short and long simultaneously
- Not compatible for IRA’s
Disclosure: The material presented on this site is for illustrative and educational purposes only. The graphs shown above represent back tested results and do not reflect actual investing results. Investing in options involves risk of loss, and these losses can be substantial. Only risk capital should be used when trading options. We do not currently own any funds discussed in this article. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. This report is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance. Do not rely solely on this research report when making an investment decision. Other factors may be important too. Consider seeking professional advice before implementing your portfolio ideas.
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