Stocks have been soaring, and the bond market has been bullish since 1981. All that could be about to change – but there’s still time to prepare
Are you – and your portfolio – prepared for a perfect market storm? Because there is a risk that a tempest may be on its way, one for which we’re woefully unprepared.
The latest piece of evidence arrived Friday, when the Labor Department announced that in spite of the deep chill that gripped a large part of the country during February, US companies managed to create 295,000 jobs during the month. That figure dwarfed the forecast by economists that employers created only 240,000 jobs while it helped send the US dollar to its highest level in 11 years.
And it’s that movement in the dollar that’s important to watch. The reason behind the greenback’s gains is one of the reasons you might want to ready the same kind of emergency preparedness plan for your portfolio that you have in place for, say, a hurricane or other natural disaster. Because being prepared is half the battle.
The fact is that we’re enjoying what are likely to be the final moments of the “Goldilocks market”. In the years since the financial crisis ended, as interest rates fell, fell again, and went lower still, the value of bonds rose. (It’s pretty logical – investors placed a higher value on the stream of income generated by those bonds, which looked increasingly appealing as rates declined.) That’s been great news for the portion of our portfolios we’ve invested in bond funds. Meanwhile,stocks soared 210.87% from their March 2009 post-crisis lows and the bull market will celebrate its sixth birthday early next week.
It isn’t that the post-crisis rally has been without its bumpy spots, of course. The European Union’s economic woes took their toll on stocks, as did the ongoing gridlock in Washington, as Congress struggled – repeatedly – to reach agreements on budgets and the debt ceiling. Bond markets, too, got the jitters as the US economy began to stabilize and Federal Reserve policymakers began to pull back their support for bonds; investors have felt the pain.
The risk we face now is that both bull markets could stall – more or less simultaneously. And we’re really not prepared for that, either in the way we think about our investments, or in the way we build our portfolios. Over the last 30 years, we’ve treated bonds as a place to take shelter whenever cyclones swept through the stock market; most of the time, that was smart. Global investors are still doing it – that’s one reason the dollar is so high relative to other currencies these days.
The most recent gains in the dollar signal something else, too. That job growth data signals that the economy may actually be stronger than expected, clearing the way for the Fed to begin boosting interest rates for the first time since before the 2008 financial crisis. The dollar? Well, investors want to own assets in the one part of the world where the economy actually seems to be growing, and to do so,they need to own dollars.
And an interest rate increase is bad news for bond investors – as those investors were already discovering last Friday, as Treasury securities reacted with dismay to the jobs data. (Again, it’s logical: as interest rates rise, the stream of income, or yield, that existing bonds generate begins to look relative anemic relative to those new, higher rates.)
Of course, a handful of modest interest rate increases – Federal Reserve Chair Janet Yellen has gone to great pains to demonstrate that policymakers have no intention of putting the economy at risk by sending interest rates soaring – aren’t going to wreak havoc. But they do mark a big paradigm change: the end to the bond bull market that dates all the way back to 1981. And anyone who tells you that he knows what it’s like to invest in bonds during anything other than a secular bull market – and doesn’t look like a contemporary of Warren Buffett – is probably misleading you. Sure, we’ve seen periods in which bond returns have been bumpy; 1994 springs to mind. From time to time, bonds have lost a few percentage points over a month or two – but more often or not, they’ve recouped those losses. That’s a secular bull market at work.
What we’re heading toward is something quite different – much bigger losses, as interest rates go higher and stay there (keeping bond prices, which move in the opposite direction to the yields on bonds, lower). And it’s going to be harder to make up those losses, because the pattern of interest hikes is likely to continue, albeit slowly, over a long period of time. That introduces a whole new set of risksinto the equation.
That would be tricky enough to manage. But ultra-low interest rates have pushed us – just as the Fed intended – out of bonds and into stocks, in search of better investment returns. And we got them, as the economy improved, and corporate earnings boomed. But in the last year or two, stocks also have begun to look very pricey, as the rate of growth in stock prices has outstripped the growth rate in corporate earnings. Now that the median price/earnings ratio for all US listed stocks is now higher than it was either in 2000, before the dotcom crash, or in 2007, before the financial crisis, stock market bears are emerging from hibernation.
The big problem is that there’s a risk that both of these bull markets will end more or less simultaneously, or at least that the endings will overlap. Here’s one possible scenario: interest rate hikes cause investors to dump bond funds and send them into stocks, which in turn drives stock valuations into nosebleed territory. Then a key company turns in disappointing earnings results – and investors panic, triggering a selloff. There are plenty of others.
What happens, when and how is up for debate. What isn’t is that both bear markets are superannuated; both bear markets are vulnerable; there are factors could cause breaks in both bear markets looming on the horizon. That means that there will be selloffs in both. The more you prepare for this now, the less likely you will be to run around like the proverbial headless chicken down the road, when others are. And that’s a good position to be in.
Part of that preparation is simply psychological. It can be scary when it feels as if there is nowhere to shelter – that you can’t simply take refuge from a stock market selloff in bonds any more. But simply panicking and storing the money in cash inside your mattress is probably the worst thing you could possibly do. The best? Plan in advance for how you’ll respond to various market scenarios – talk it through with your adviser, your partner, or your investment club members. Trying to respond to every bit of news in one market selloff, let alone two, is tricky: timing the market, in the absence of a perfectly functioning crystal ball, is a pretty bad idea.
You can also rethink what is in your portfolio. Instead of viewing it as simply a collection of stocks and bonds (so 20th century), view it as a set of investments with different characteristics: some generate income; some exist to provide income and stability; others are riskier but provide more growth. Some advisers have urged their clients to look at new kinds of income-yielding securities in place of bonds. Master limited partnerships, for instance (those that aren’t exposed directly energy prices) offer bond-like returns but aren’t bonds; so, too, are real estate investment trusts. Some investors have turned to ultra-short bond funds as a temporary tactic. Instead of buying a large cap index fund, some pundits recommend looking for stocks that have specific characteristics, or factors, that will enable them to fare better, even in a bear market.
We’re about to enter a brave new investment landscape. There’s still time to get ready.
http://www.theguardian.com/money/us-money-blog/2015/mar/08/bull-market-stocks-bonds
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