Historically, it has made reasonable sense for retirees to have a sizable allocation to bonds. A minimum of 40% was certainly not uncommon. The logic behind this was that retirees regularly draw from their accounts and are less comfortable with the enhanced volatility that stocks can at times provide. The supposedly steady income from the bonds provides money for the retirees to live in. This has been the status quo over the last 35 years or so, in a predominantly declining interest rate environment.
Now however, the world has tilted a little bit in a way in which economists once deemed to be impossible. Roughly $13 trillion in assets have negative yields, meaning that investors are paying to lend their own money. They do this out of fear and on the bet that others will pay even more for their bonds, which is known as the Greater Fool Theory.
Coinciding with this is a financial services industry that has gone a bit batty in my personal opinion. 10 years ago, most investors and advisers were scared to recommend a heavy allocation to stocks, having lived through the Financial Crisis. Instead investments such as gold coins, or alternative assets such as commodities seemed to deserve a much larger space in the portfolio. But now after a 10.5-year bull market, the current consensus is that it is best to take a value agnostic approach to investing. Just hold index funds and as long as the market goes up you should be okay. The majority of market participants are investing in a manner in which they don’t care how expensive stocks are relative to intrinsic value, or what the future likely returns of the bonds they own are!
This is not hyperbole, it is a reality. You usually only see this type of flawed logic become a consensus in periods of substantial excess similar to how it was in Tech Bubble, or during the Nifty 50.
Clients of TTCM are not going to fall into this illogical trap. We employ more tools at our disposal than 99% of advisers or fund managers. Firstly, individual stock selection positions us in only the most attractive priced opportunities that we can find. We don’t follow the market like sheep. Secondly, we are able to create a far more favorable risk/reward than the paltry yields of bonds, via utilizing cash-secured put and covered call strategies. Bond income is taxable, just like the income from options selling is taxable, but the return potential is 3-4 times higher in the current environment.
Market participants that don’t have these tools at their disposal are often shifting way too much of their portfolios into stocks at too high of a valuation, leaving them susceptible to a 30-40% drop, and for retirees the timing likely couldn’t be any worse. We are at the point in the cycle where we have to be very smart about everything that we do. If we get a good Brexit resolution and an improved Trade Environment, stocks and the global economy could potentially push higher. Interest rates are so low, that the hurdle rate for stocks is much lower than it has ever been. However, the risks are quite significant for the overall market. Interest rates can go up and a recession is likely overdue. As I’ve said before, I wouldn’t be shocked if we are in or close to a technical recession due to extraneous factors such as the GM strike, the Boeing manufacturing woes, etc. That wouldn’t worry me or change our investment philosophy one iota.
The first couple of days of earnings are off to a strong start with very good results for all of the big banks. I’m still skeptical about the Trade Deal and I am hopeful on Brexit and feel that an amicable resolution would lead to massive gains on our European financial stocks. We have already seen some big movement and they have a long way to go to reach intrinsic value.