Introduction
Bonds, stocks, and commodity prices are
sending different clues while the pundits proclaim synthesized global economic
growth. After thirty-six years of rising returns for fixed income, almost a
decade of stock market gains, and commodity prices entering a new cycle,
thoughtful market participants are confused. The one common impetus is growing
confidence in decision-making. With more confidence investors are consciously
or not accepting more risk because they are getting a somewhat clearer view of
the future. As a contrarian, and often allergic to popular views, I have my
doubts. I am not totally alone. Ian Bremmer of the Eurasia Group has said,
“2018 feels ripe for a big unexpected crisis." My concern is that the growing
confidence is crowding out a reserve for surprises, good or bad.
Inverted Yield Curve Fear
While it is true that the last seven
fixed income prices declines came after the 2-10 year US Treasury yield curve
inverted, I do not believe it is an immutable law of investment science.
Nevertheless, it is a proper place for study. There is a similar pattern in the
futures market when near-term investments are more expensive (higher yield)
than long-term ones. What is important is that the market view is that the
near-term future has more risk than the longer-term. Often this is right, but
not always. Remember the surprise factor. In my opinion an inverted yield curve
if and when it happens is more descriptive of current fears than predictive of
long-term prices. Fixed income prices are set by supply and demand and are
similar to the odds posted by book makers which are not the result of careful
analysis but prices that will bring new bets into balance to keep the bookmakers’
capital risk into reasonable balance. The bookies and the bond market will lose
out only if there are too many surprises.
The fears that there are oncoming
inverted yield curves or other causes for bond prices to decline have been
operating for the last few years. The biggest concern is not credit losses, but
inflation. To service those who are concerned that inflation will rise above
current levels, the US Treasury and others have created TIPS (Treasury Inflation
Protected Securities) funds which are issued in roughly the same maturities as
the other treasury paper. For more than the last three years the total return
investment performance of the average TIPS fund is slightly better than the average intermediate US Government
Securities fund. For longer periods the reverse is true. One wonders what the
relative performance results would be when the reported inflation rate finally
reaches or exceeds the Fed desired 2% level. It is possible that our and others
are from time to time paying premiums to buy inflation protection and this is
why the TIPS funds perform better rather than their pricing mechanism?
If one is managing retirement capital
accounts for those that are currently working, I would substitute 30 year
treasury yield for the 10 year. (More on this later.)
Individuals investing in fixed income
securities or funds should separate the total return numbers between income
(interest) payments and market prices. Inflation will not nominally impact the
income stream, but may have significant impacts on both the prices of the bonds
and the purchasing power of the proceeds.
At Caltech and other places studying how
the brain makes decisions, they have found that most humans make decisions on
finding past memories that coincide with current conditions. Every now and
then, the occasional winner will see the current situations as sufficiently
different than the past that they opt for a new strategy. In other words the
preferred algorithms will give way to new thinking and actions.
Stocks Are a Confidence Game
Almost every prognostication from brokers,
advisors, and commentators in terms of the stock market were expansive. Two recent examples display the
enthusiasm for the stock market are as follows:
“Investors Intelligence” tracks letter
writers in its latest report in Barron’s;
64.4% are bullish and only 13.5% are bearish. In approximately the same period
the AAII weekly survey showed a significant reversal in their volatile report
with the bulls declining to 48.7% from the prior week’s 59.8% and more
significantly the bears gained to 25.1% from 15.8% the prior week. The AAII
sample shifts each week which could have caused the changes and this week some
were more worried about the impact of the bond market or were reaching to
political news.
Commodities are Active
Based on perceived increasing demand from
China and rising demand from US manufacturers, industrial metal prices are
rising. In a classic example of a surprise, the price of oil touched $70 a
barrel this week and there is a press story that some expect the price to reach
$80 this year. In response, over the last four weeks the best performing mutual
fund investment average is the Natural Resources funds, up 12.66%. As a
contrarian and a long-term investor I am wondering when the increasing population
and shrinking farming land will be seen in rising prices for grains. This
hasn’t happened in a long time.
Very Long-Term Outlook
The latest available estimate of the
global retirement savings gap in 2015 was $70 trillion and by 2050 it is
estimated to be $400 trillion. Thus, in only 35 years there is a need for over
five times more capital to be invested for retirement. (This is why I suggested
using the 30 year yield for the spread calculation.) How should one invest to
meet this long-term need? I do not believe that today one can evolve a
consistent investment policy to meet these needs. My contrarian nature suggests
that it may be easier to identify what not to do. The average S&P500 mutual
fund beat 90 out 96 mutual fund investment averages for the last five years and
84 for the last ten years. I don’t think that will continue. The best
performing hedge funds in 2017 were invested in large caps and securities
driven by momentum (FAANG + 2 from China).
Different strategies at different times will be needed to avoid losses
and achieve gains. This is why I believe that a portfolio of different funds or
managers is the most prudent for the long-term.
Question of the week:
What are the most prudent strategies for the long term?
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