What should an investor do? Markets are confounding. They appear to be almost predictable. Until they’re not!
We are in an investment environment that reminds me of the technology bubble 16 years ago, and the markets are partying like it’s 1999. Today rather than focusing only on the technology sector, perhaps we should examine both the bond market and the equity markets in their entirety.
We have been trained and told over and over and over again since the 2008 financial crisis the Federal Reserve has our backs. Indeed they have engaged in unprecedented monetary policy never in my lifetime would I have thought possible.
In addition to the Fed taking on dual mandates established by the U.S. Congress of full employment and stable prices, it appears they have created numerous other policies: creation of a minimum of 2% inflation; not raising interest rates due to (fill in the blank) Brexit, various and sundry economic data, negative monthly payroll reports, concerns about foreign economies such as China, currency issues, etc.; controlling the stock market upward – Chairman Bernanke called it “The Wealth Effect.”
As a result we have been at near-zero interest rates (ZIRP) for eight years, seen the Fed buy 4.5 Trillion bond securities from money creation through various schemes called Quantitative Easing, Twist, etc. In addition we have seen major banks, both domestic and foreign, bailed out with unprecedented amounts of money. They’re even open to the possibility of NEGATIVE interest rates!
As a result of all this we have arguably the most distorted stock and bond markets in history! Both bonds and stocks are at all-time highs, and the stock market made another historic high as I write this article.
What should an investor do, and what’s not to like you may ask?
The distortion created by effectively zero interest rates can result in many unseen consequences. The Mises Institute in “The Unseen Consequences of Zero-Interest-Rate Policy” names a number of them:
- Conservative investors by nature come under increasing pressure with respect to their investments and take on excessive risks in light of the prospect that interest rates will remain low in the long term. This leads to capital misallocation and the emergence of bubbles.
- The sweet poison of low interest rates leads to massive asset price inflation (stocks, bonds, works of art, real estate).
- Structurally too low interest rates in industrialized nations due to carry trades lead to the emergence of asset price bubbles and contagion effects in emerging markets.
- Changes in human behavior patterns occur, due to continually declining purchasing power. While thrift is increasingly mutating into a relic of the past, taking on debt comes to be seen as rational.
- As a result of the structurally too low level of interest rates, a “culture of instant gratification” is created, which is among other things characterized by the fact that consumption is financed with credit instead of savings. The formation of wealth becomes steadily more difficult.
- The medium of exchange and unit of account function of money increases in importance, while its role as a store of value declines.
- Incentives for fiscal discipline decline.
- Zombie banks are created: Low interest rates prevent the healthy process of creative destruction. Banks are enabled to roll over potentially non-performing loans practically indefinitely and can thus lower their write-off requirements.
- Newly created money is neither uniformly nor simultaneously distributed amongst the population. This results in a permanent transfer of wealth from later receivers to earlier receivers of newly created money.
What does all this mean to investors? In my view there are two critical takeaways in analyzing these issues:
- Extremely high stock valuations: Many corporate share buyback plans and dividend issuances have been done through the use of cheap debt, which has led to increases corporate balance sheet leverage. This will eventually end. Financial engineering like this has also reduced the amount of capital investment that results in growing companies in favor of elevating the stock price, reducing the outstanding share count, and showing better Earnings Per Share. However the dirty little secret not being discussed is we have seen 5 consecutive quarters of LOWER earnings in the S&P 500. Here is a chart from “Q3 EPS Expectations Just Turned Negative: Six Consecutive Quarters Of Declining Earnings” at Zero Hedge:
As a result of this distortion, the Debt-to-Earnings ratios are at the highest point of the CENTURY:
- Historically high government debt, corporate debt, and personal debt in this country. As any financial planner knows, the more debt one has the less flexibility one has in many ways, even beyond financial. That’s where we are today. I won’t bore you with a chart of U.S. Government Debt, but here’s a chart that shows the credit created since the financial crisis in “What Happens When Rampant Asset Inflation Ends?” by Charles Hugh Smith:
As a result of record high valuations, we look to place more emphasis on the return of your money than a significant return on your money. While there are many ways to reduce risk, here are five to consider:
- Reduce equity exposure in your Asset Allocation
- Reduce risk in the equity allocation you continue to own – some techniques are large-cap stocks vs. small-cap, reduce emerging or international markets, etc.
- Reduce credit risk in the bonds/fixed income you own – we already have begun to see signs of stress in the fixed income markets – we are VERY wary of any positions below Investment Grade
- Reduce Interest-Rate Risk – pay close attention to the maturities of bonds and fixed income in your portfolios – reduce the length of maturity to reduce interest rate risk
- Maintain greater than normal Cash positions – while rates are still ridiculously low, remember we are focusing on a return of your money
If you have a trusted financial advisor, we recommend reaching out to them before the end of the summer. If you’ve been partying like it’s 1999, at least get a designated driver. It’s time to reassess where you are in your own financial journey in context with where we are in the markets. If you don’t have a trusted financial advisor, we recommend a professional with the Garrett Planning Network.
Of course we are always happy to help at Financial Freedom Planners in an objective, fiduciary manner without conflict of interest!