Things that Go Bump in the Night: What Fear Means for Investment Portfolios
“The fact that people will be full of greed, fear, or folly is predictable. The sequence is not predictable.” – Warren Buffett
Breaking News: The stock market is going to go down. Probably by at least a little, possibly a lot. If you’ve been reading our letters for a while, you’ve heard our common refrain: “10% once a year, 20% every five years and 30% (or more) every ten years” is a reasonable estimate for how much you can expect the stock market to drop from a peak to a new low before starting to work its way back up again. We don’t know when the drops will occur, we just know they will happen, and the key is that it always seems to climb its way back up (eventually). As our opening quote indicates, the market sentiment pendulum has a tendency to swing from extreme greed to extreme pessimism. That much we can know for sure.
As Halloween is quickly approaching, the appropriate question out there is: what is lurking in the shadows that could trigger the next slide? (Reminder: we haven’t had the “big one” in quite a while, so that is obviously a reasonable concern on many peoples’ minds). Depending on what side of the political spectrum you sit, you may be biting your fingernails about Frankentrump, or maybe it’s a Vampelosi. Seriously though, there are scary things out there – Iran attacking Saudi Arabia, a looming trade war, natural disasters, Hong Kong protests – all on top of a now potential impeachment proceeding. Yet, the stock market continues to work its way upwards (the S&P500 is up >19% YTD!).
However, we’d like to discuss a monster that keeps us up at night as investment advisors: The Yield Monster (sorry for the lack of creativity on the name). This “monster” represents the glut of global savings in the world. Perhaps there was a time when it was a nice, well-behaved creature, but as slowing global economic growth starved it from nourishment through traditional investment (i.e. new productive plant and equipment) it set out on a rampage to consume every bit of yielding asset in the world (bonds, real estate, dividend stocks, etc.) thus driving down yields and pushing up prices (there’s a reason why the top performing stock sectors over the last 12 months are: Utilities, Real Estate and Staples – the traditional “income” stocks).
This Monster’s yield binge started small, but then its unsated appetite enticed countries and companies around the world to issue more and more yielding assets for consumption, including debt at negative interest rates – some $17 trillion worth – to keep the monster at bay. This makes the U.S. 10-year Treasury Bond rate of 1.68% look all the more attractive (just think, it was 3.06% a year ago). And scariest of all, is perhaps the return of “alphabet soup” assets that taste like yield but are really just toxic to The Yield Monster (a nasty term called “structured” finance: CLOs, CDOs, CMOs…you know, all the stuff that got us in trouble in 2008). Let’s just say, if someone offers you an investment opportunity with an above-average income stream, but with purportedly lower-than-average risk, run. Fast.
Bear with us as we carry this tongue-and-check analogy one step further to Monetary Policy (the influence of central banks on yield). Across the globe, the Fed, the ECB, the JCB, the BOE, and others have essentially been pulling all the stops to keep the cash flowing in an effort to satisfy the Yield Monster. What started out as a defense mechanism, now seems like a never-ending life-support system for the yield-craving economy.
But can the Global Central Banks (“GCBs”) save us or just delay the pain? Without a doubt, we are starting to see how some of the tools and decisions by the GCBs will be tested. For example, in September we witnessed a small “clog” in the plumbing that the US Federal Reserve Bank uses to keep cash efficiently flowing in the economic system (the “Repo” market, if you have been following this at all). Perhaps this was just a small fluke, but as this plays out, we are seeing both rates being cut, AND the Fed considering buying assets again to keep the Yield Monster at bay (and continuing to drive rates lower). The irony, of course, is that these were the same tools used to stave off a crisis, but we are on the complete other side of the economic cycle now in the U.S. with low unemployment and stable prices (to QE-infinity and beyond?)
OK, take a breath and come out from beneath the sheets you are hiding under. Our goal was not to scare, but to inform. Our best defense is a plan of action, and that’s why we love what we do – helping our clients build and execute successful investment strategies. You know already that it’s a balancing act between taking smart risks and achieving investment objectives. While the stock market carries ample risk, we know that participation in the long run is still the best bet for maximizing return versus just holding bonds and cash (gee, thanks Yield Monster). And bonds are still necessary (albeit, positive-yielding, high quality bonds) to balance the risk in the portfolio while providing the steadier cash flow needed for those in the “distribution” phase of the investment plan.
Sound like a broken record yet? Hopefully. While our primary objective is to smartly allocate client funds to investments that appropriately compensate holders for the risk taken, the other equally important task is to help our clients develop the right plan and strategy for the goals in place – then STICK to it. Most of the time, that also means staying the course as long as we continue to make sure the assets position the portfolio to benefit the most from the current dynamics of the market while staying appropriately exposed for the longer-term.
Thank you for your continued trust and confidence. Please feel free to send us a message or give us a call anytime. Have a safe and enjoyable fall!
Norris, Perné & French