Most financial advice starts with an asset allocation model. These asset allocation models typically use information from the past, typically the last 30-40 years or so, and then project that into the future. The big flaw in the process is that they don’t factor in changes in starting conditions and valuations. For instance, on January 1st, 1982, the 10-year Treasury yield was 14.59%. On July 10, 2019, the 10-year is at 2.07%. This massive downward trend in interest rates has been rocket fuel to both equity and fixed income returns. Is it realistic to expect the same returns going forward, with these starting conditions, including record valuations for the S&P 500? Imagine a whole industry that does it this way, and it is no wonder at T&T Capital Management we aren’t willing to simply follow the crowd.
If someone was creating a financial plan for you in the year 2000, they could juice up your “projected” returns by loading it with tech stocks, yet tech stocks went on to drop by 80%. In the mid-2000s, BRIC (Brazil, Russia, India, and China) and housing were the stylish investment choices, only to be meant with misery. Now is year-10 of this bull market, U.S. stocks and technology are dramatically overweight for most investors due to their recent out-performance.
For us in the United States, it is difficult to imagine that the IShares MSCI AllWorld ex U.S. stock index has only appreciated by 1.7% per annum since December 31st, 2007. This was after a period of substantial out-performance versus U.S. stocks. Many investors were overweight international stocks based on the ideal “model asset allocation” that their advisor provided them. It is a huge mistake to expect the recent past, to continue into the future.
As we look at the markets now, we see few places to hide. Just this week, Germany sold a new 10-year Bund with no coupon. Investors paid a record yield of -0.26% to lend Germany money, meaning they will get back less than they lent at maturity. With dynamics like this, fixed income risks are stacked against the long-term investor. Despite this, many market participants have 20-60% asset allocations to fixed income, because over last 30 years, it has done okay. Now, many of these people invested in bonds, also aren’t comfortable with the inherent volatility that comes with being invested in stocks. I personally think it is crazy to be 100% long index stocks at current prices. Then if you are thinking about just sitting in cash, we are likely going to see deposit rates cut again, starting in July with the Fed easing rates.
These are real problems, but there are also real solutions. By searching the world for just the handful of attractive investment opportunities that we need, we can find ample opportunities to continue to perform well. There are some real opportunities in Europe and individual U.S. names that we think could lead to double-digit returns over the next 5-10 years. Stocks like Assured Guaranty and Ambac aren’t likely to have future returns too highly correlated with the overall index, as they are reliant on various legal and negotiated outcomes to determine future value. A stock like Berkshire Hathaway provides you with the best money manager in the world sitting on a growing war chest of over $100 billion in cash, ready to pounce on the next major market disruption. In addition, we can adjust for the horrendous fixed income environment with the creative use of options to generate income and reduce risk.
In a bull market, just about every stock sold seems like a mistake. In a bear market, nearly every stock bought seems like one. This is the balancing act that is prudent money management. There are times when it is necessary to swing for the fences, and there are times when we need to batten down the hatches. We see an ability to get more aggressive on some of these cheap European stocks, but we also see the U.S. market as looking very frothy. It can be tempting to see people making a fortune on every SAAS (software as a service) stock, but keep in mind that many of these stocks face the risk of being cut by 80% or so. I’m not talking about Facebook or Google, which are wildly profitable and aren’t valued at these stratospheric levels, but some of the smaller names are a screaming bubble at current prices.