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Out of Balance Part II

In 2014, we conducted one of our Solution Series webcasts called “Getting Out of Balance”. The webcast was predictive at the time suggesting that investors avoid becoming complacent about the safety and security in things call Balanced Funds, or Life Strategies or Target Date funds. These types of funds tend to own a prescribed mix of stock index funds and US Treasury bond funds usually in a 60/40 split respectively. These funds represent $ Trillions of dollars inside 401k and other retirement plans as they have successfully appealed to investors who like the idea of robotic investing solutions. Historically, these funds have done well as bonds have done their job in providing healthy returns plus a safety net when stocks fall. I firmly believe those days are coming to an end and investors are going to need to consider a more unbalanced solution if they want to continue making reasonable returns in the future.

 

Where’s My Safety Net?

 

For nearly the last 25 years, investors have grown accustomed to the fact that bonds move inversely with stocks. When stocks fall, bonds rise right? And with that relationship, we can easily build a well-diversified portfolio of stocks and bonds (aka balanced funds) that move ever higher with tolerable portfolio volatility. But the success of this magical portfolio relies on a few key ingredients. The relationship between bonds and stocks must generally be one that is inverse on a weekly and monthly basis. But more importantly, we must also have longer term rising trends in both stocks and bonds (prices). After all if one of our two major food groups enters a protracted decline like something we have seen in real estate, Japan, or Gold, then that major food group fails to carry it’s weight in our balanced portfolio or fund. Treasury bonds have been in a 25 year bull market through all types of economic environments. The bond uptrend has only seen periods of acceleration when stocks move into bear market declines as they did twice in the 2000’s. Now fast forward to today. Treasury bond yields are (were) very nearly approaching their lowest levels in history and offering close to negative rates net of real inflation (2% ish). The same thing has happened to the bonds (Bunds, JGBs, etc.) of all developed nations around the world. All have approached the zero line in terms of yields with literally nowhere to go but up. Some countries are dabbling with negative real yields in the context of desperate attempts to spark economic growth but of course this is not sustainable. German Bunds are now reacting to nothing more than the underlying unattractiveness of this asset class and global investors are dumping them as quickly as possible. In the last couple weeks, German Bunds, once thought to be one of the world’s greatest safety net type investments have just caused incredible wealth destruction. Here’s a five-year picture of the 10-year German Bund Yield. The recent move up in yields, down in price, is significantly more meaningful as these rates are coming off of the zero line.

The same story and the same risks are now present in the US Treasury bond market. The US bond market safety net might very well be broken already. Since the end of January, the 20 year US Treasury bond is down almost 12%, -4.5% YTD. Balanced fund investors haven’t really noticed yet as stocks are up about 6% since the end of January, but only up 2% YTD. They are looking at monthly statements now with a quizzical look wondering why their account is still stuck at zero or more likely negative YTD depending on the stock/ bond split. The message to all investors is this. Be aware of the fact that developed country bonds are now under heavy selling pressure. These have been the safety nets to global investment portfolios for years. Consequently, I believe there is a strong likelihood that developed country bonds are going to become dead money for quite a while until rates move substantially higher over the course of years and all things resembling a “balanced” fund might get very unproductive from a return prospective.

Good News for Tactical Stock Investors

While I hate to lose an asset class as large and as giving as the US Treasury bond market, I’m happy to say that the End Game for the US bond market might be an enormous tail wind to tactical shops like ours. In the last year, we have tactically reduced our exposure to bonds of all types in our blended asset models to less than 20% and moved to other types of bonds and income bearing securities in our pure income models. All stock models are always all stock of course. In place of bonds, we have beefed up our allocations to alternative securities all of which are doing very well in providing stable, non-correlated returns to our portfolios. We are also carrying a higher weight in stocks versus bonds, as that is where returns are still available. The relative performance has become more pronounced in recent weeks.

Our tactical methodology identifies relative strength among asset classes, styles and sectors and dynamically allocates our client’s money accordingly. We are not stuck in a prescribed 60/40 mix of market indices of any type. Many are of the belief that rising bond rates are bad for stocks. Historically, that isn’t true until interest rates move well above 5% (10 year). We are currently hovering just above 2%, so a long way away from 5%! In the current environment, rising rates are almost constructive to stocks outside of those sectors dependent on forever-low rates or companies operating with high debt to equity. Selling pressure in our bond market will factually drive investor capital to new investments probably those paying some interest like equity dividend payers again, so the event sort or creates underlying buying pressure for stocks. At the same time, we’re seeing investor sentiment numbers at some of the lowest readings in years as of last week. Very low “bullishness” readings are often excellent buying zones for stock investors. For those in the tactical world, considering the new selling pressure in the global bond markets, we might now be ready for a healthy stock rally through the summer perhaps into July. Lowry’s Research just gave a new “Buy” signal for stocks at the close on Friday, just as everyone was getting comfortable with the idea of Sell in May and Go Away. It’s never just that easy is it?

 

Now get outside and enjoy the springtime!

Sam Jones

President