Riding the cycles: Monitor rates, stay diversified
Long-term results moot if you falter in short term
Michael MaehlApril 13th, 2017
Currently, we’re trading near the all-time highs of the U.S. stock market, while the bond market continues near its all-time lows. This cyclicality aspect of the markets is leading many to conclude that the time may be coming near for them to trade places.
I believe that any talk of actual change in these trends is premature, at best. Here are some thoughts and facts to help you understand why I say that.
The first thing to understand is that the stock market is ruled by long-term and short-term interest rates. Of the two, long-term rates are more influential. The movement of short-term and long-term rates influences which types of stocks do well.
In stock market investing, there are a few general terms that cover most stocks, regardless of the specific industry it may be in. These are Cyclical and Defensive, as well as Growth and Value.
When long-term interest rates are rising, cyclical stocks tend to outperform the overall market. By cyclical stocks, I mean stocks in sectors like energy and materials, which are closely tied to the economic cycle. When the long-term rates fall, defensive stocks tend to lead the market. The defensive sectors include such areas as consumer staples and health care, as these are areas that usually aren’t hurt as much in downturns.
With short-term rates, we see a similar but slightly different effect. When short-term rates fall, value stocks outperform. Value stocks are generally in high-dividend areas, such as real estate investment trusts (REITs) and utilities. When short-term rates rise, growth stocks tend to lead. Growth stocks tend to be in low-dividend areas like tech and more inflation-sensitive sectors like commodities and gold mining.
When the difference (i.e., spread) between long- and short-term rates widens, meaning they move in opposite directions, cyclicals and financial stocks tend to do well. As the spread narrows, the defensive stocks tend to do well.
Looking at these past experiences, and with short-term rates rising slowly and long-term rates holding steady right now, it would appear that growth and cyclical issues may be more in favor. Importantly, these are usually short-term relationships that grow weaker over time.
It’s my opinion that, while the market today isn’t cheap, neither is it overpriced. Continued low interest rates—potential near-term Fed increases notwithstanding—help to support market values. Additionally, one of the data points that most of the “less bullish” folks want to focus upon is, in my mind, flawed.
I’m referring to the CAPE ratio. CAPE stands for the cyclically-adjusted price-to-earnings ratio, created by Nobel Prize-winning economist Robert Shiller. The ratio uses the price of the S&P 500, divided by the moving average of 10 years of earnings, adjusted for inflation.
People who adhere to this valuation method say it smooths out the economic cycles and, therefore, better reflects the true value of stocks. The current level of the CAPE has only been seen twice before—once just before the 1929 selloff and again in 2000, when the dot-coms blew up. Because of this, the CAPE disciples are running about saying, “Watch out – dark days are ahead.”
You know the market theorem that says “past performance doesn’t predict future results”? I maintain that’s very much the case with the CAPE ratio. As noted above, averaging 10 years of earnings might make it smoother, but to me it also makes CAPE extra backward-looking.
That’s because the CAPE still includes earnings from 2008-2009’s recession. How are those relevant now? Markets weigh future profitability, not what happened a decade ago.
Heck, two years from now, CAPE could fall just because those recessionary earnings have fallen out of the 10-year calculation. So, would it then suddenly be bullish?
The goal of CAPE’s creators was to forecast the next decade, not as a short-term trading indicator. Even if it’s used “properly,” CAPE seems suspect. Stock prices are determined by supply and demand. So, to forecast long-term stock returns, you’d have to be able to predict the stock supply. No one knows how to do this. CAPE doesn’t even try, instead relying on past information, which markets have already factored in to prices.
Try looking at CAPE differently: When investors are fearing CAPE and overvalued markets, skepticism lingers, thus creating the wall of worry. Meltdowns happen when investors are too euphoric. Melt-ups happen as animal spirits awaken and confidence grows. Those are stirring now.
High valuations can often get higher. Valuations aren’t predictive. It’s also an incorrect assumption that the level of the markets indexes themselves can create a downward pull on stocks. Individual stocks, and the market, can stay massively over- and under-valued for very long periods of time.
When investing in the bond market for the longer term, your beginning return has been the single best predictor of future bond returns. In other words, the lower your starting yield, the lower the future return, and vice versa.
According to the folks at Pension Partners, five years ago, the yield on the Barclays Aggregate Bond Index was 2.24 percent. What have bonds done since? They found that the two largest bond exchange-traded funds (symbols BND and AGG) have returned 10.04 percent and 10.28 percent—cumulatively—or 1.93 percent and 1.98 percent annualized. As was predicted by their low beginning yields, these are among the lowest five-year returns in history; the annualized return for the Barclays Aggregate since 1976 has been 7.5 percent.
You can’t change bond math. What we can do is talk about what, if anything, you can do about it. Long-term, low single-digit bond fund returns aren’t something most investors, both retail and institutional, are prepared for.
What can you do? There are three main options:
*You can decide to take more risk by placing more of your fixed-income assets into higher-yielding bonds in either the U.S. or emerging markets.
*You can take on more risk with a higher allocation to stocks.
*You can save more, spend less, and retire later.
The first and second options may require changing your risk tolerance. This usually isn’t easy, or advisable, for most investors … particularly those nearing retirement. These also assume that returns will be sufficiently higher in the other asset classes to pay you adequately for the additional risk.
This then leaves us with the least desired but also the most realistic option of the three: expecting lower returns in the years to come and adjusting your lifestyle accordingly. Save more, spend less, and retire later … but who wants to hear or do that?
The only long-term cure for low bond returns is for interest rates to rise much higher, a low likelihood for the foreseeable future.
What to do
I believe that the best thing most investors can do to help deal with the normal uncertainties of the markets is to be well-diversified across market sectors. Trying to position yourself heavily in one sector isn’t investing, it’s fortune-telling.
Here are a few points about the markets and investing that also may help you stay the course of your personal investment strategy. If we can learn anything, it’s how trivial the great long-term results may be if you can’t survive the short term.
Uncertainty about the markets is always present and it’s definitely not to your benefit to use it as an excuse to not invest.
Diversifying over sectors is about the only way you can protect yourself from market uncertainty. Diversification works, just not every year. Diversification means it’s likely something you own will always be out of favor. Welcome to market cycles.
I’m well aware that this bull market will eventually end, but that end doesn’t seem anywhere close today. And though sentiment has improved some recently, market optimism typically lasts for long periods before markets peak. Typically, bull markets accelerate to their peak, with large portions of total return coming in the last third or so.
Michael Maehl is a financial adviser and Spokane-based senior vice president of Opus 111 Group LLC, a Seattle-based financial services company. He can be reached at 509.747.3323. Securities and investment advisory services offered through KMS Financial Services Inc.