“Don’t put all your eggs in one basket.” 

2022 has been a good illustration of this saying for investors.  Both stocks and bonds declined.

It is true that, over the long term, stocks can appreciate from earnings growth, dividends paid, and price expansion.

That does not mean that stocks go up each and every year, especially when valuations are high and interest rates are rising (like now).  There are times to load up – and times to lighten up.

Currently, bonds that earn less than inflation won’t help investors achieve their objectives to grow and defend principal.  (Until these conditions change, you are unlikely to see a lot of fixed income in your portfolio.)

Hence, we have committed a lot of resources and time to seeking other diversified investments.  We are very selective about what you own.  It is arduous to separate the wheat (tenured managers with success that has the potential to repeat for current or new investors) from the chaff (most hedge funds and REITs do not deliver and simply charge expensive fees).

We also demand that they are liquid (you can invest or take money out any working day of the week) and transparent (daily pricing by a reliable third party).

This short blog will tell you a little how your “diversified” investment bucket might help your portfolio.

Introducing a New Strategy to Your Portfolio

In our last newsletter, we mentioned our caution on traditional fixed income.  Rates and credit risk were not enough to compensate for inflation and other risk.  Consequently, cash balances in your account were high.

Recently, we added a new investment strategy that potentially provides some of the positive characteristics of traditional fixed income with potentially lower risk.  This is called “merger arbitrage”.  When an acquiring company (or private equity) announces it will buy a target company, it requires time and regulatory approval before the deal is completed.  The current price of the target company does not fully reflect the acquisition until the deal is completed.

Such a discount creates opportunity for merger arbitrage funds to make money.  Presuming their due diligence on the deal going through is correct, they earn returns by buying the shares of the target company and hedging market risk by selling (going short) of the acquiring company.

The potential benefits to investors might include: (1) steady, positive returns over time, and (2) limited equity market risk due to hedging.  Possible risks include deals falling through and drastic reduction in the opportunity set of deals in which to invest.

Merger arbitrage also has the potential to benefit if interest rates continue to rise, since they can generate higher income on cash invested in deals.  In that sense, merger arb resembles a short duration bond strategy, perhaps with higher potential returns.  (In contrast, many parts of traditional fixed income might be hurt by higher rates; investors might sell high duration and credit risk in favor of a higher, safer yield on money market assets.)

Seeking to Make Money in Rising and Falling Stocks? 

Another manager in your diversified sleeve is an equity long-short strategy.  (This fund is closed to new investors and can only be accessed through select advisors like us.)  The manager invests in securities with solid businesses and cheap valuations on the “long” side while hedging by selling stocks with poor fundamentals and expensive valuations on the “short” side.

The chart below suggests that most managers have reduced or given up investing in falling stock prices for the average stock in the S&P 500.  Less competition might open more opportunity for managers that seek to make returns in part through falling share prices.

We remain cautious on most traditional assets.  Since the market rebound from the June lows, sentiment has grown too optimistic.  While bears talk at cocktail parties and AAII sentiment surveys, they are not putting their money where their mouth is.  For example, the average investor at Bank of America still has very high exposure to stocks (measured as stock allocation as a percentage of total investments).

Indeed, it is close to the all-time high only a few months ago and well above average levels from 2009.

Commodity Investments Ride the Inflation Wave

Your portfolio might also include shares in commodities, including an active mutual fund manager and passive exchange-traded strategies.  Supply constraints and concerns of a weaker dollar might continue to push prices upward over time.  Risks of lower demand from slower economies also exist.

You can read more about our thoughts on commodities here and here .

Conclusion

In bull markets, people typically focus on returns over risk.  But when the markets change, they are reminded that risk still exists.

Let’s be clear.  No one (we ourselves included) can promise you a portfolio without any risk.  It is impossible.

Even getting out of bed in the morning entails risk (you could fall, for instance).  But you do it because most of the time, something good happens.  Even when bad things do occur, the good far outweighs the bad over time.  (Staying in bed all day also entails risk to your health.)

What we seek to do, however, is to take prudent risks.  Not all risk is created equally.  Not all risk is equally likely to happen or incurs damage to your portfolio.

That is why you will see a number of investments of your portfolios, including a chunk in what we call the “diversified” bucket.

If you know someone whose nest egg has been beaten up in the market and needs help to stabilize things, please let us know.  We are here to help.

The post Investment Update: September 2022 appeared first on AWM.

We believe fixed income is an expensive asset class, but that does not mean investors should totally discard its use in diversified portfolios.

Current yields in nominal and real terms are near historic lows.

Foreigners hold roughly 6.3 trillion of the 20 trillion dollars in total public debt of the United States or roughly 30%.[1]  Japan and China hold $1 trillion each and comprise the 2 largest foreign holders of Treasury debt.  For context, the US Federal Reserve holds roughly $2.5 trillion.[2]  Adding the numbers together, foreign nations and the Fed hold roughly 40% ($8.5 of $20 trillion) or 4 out of every 10 dollars of US Treasury debt.  Monitoring the actions of these debt holders is crucial to forecasting the direction of interest rates on Treasuries.

The US Federal Reserve has indicated its preference to tighten short-term interest rates and eventually reduce its position in US Treasuries gradually over time.[3]  Tighter domestic monetary policy might add greater volatility to bonds than the low levels of recent history.

China is another wild card in terms of future actions.

As the largest exporter to the US and the largest central bank in the world in terms of foreign reserves, China would appear to have a long-term interest in maintaining its current large position in US Treasury debt.  If China were to reduce its Treasury position, it might potentially induce a sell-off in the US Dollar and currency appreciation in the yuan, a situation that could hurt profits for Chinese exporters.  China’s large Treasury holdings possibly offer a hedge against the risk of rising trade protectionism from the US.

On the other hand, China might see political benefits in promoting greater use of its own currency in lieu of the US Dollar in foreign trade.  For example, China is preparing to trade futures contracts on oil and gold denominated in its local currency.  In theory, oil exporters such as Russia and Iran could bypass sanctions and trade in Yuan.[4]

Any reduction in China’s holdings in US Treasury debt potentially could add to bond market volatility.

Schedule appointment

[1] http://ticdata.treasury.gov/Publish/mfh.txt  accessed on October 23, 2017.
[2] https://fred.stlouisfed.org/series/TREAST  accessed on October 23, 2017.
[3] http://www.businessinsider.com/fed-statement-balance-sheet-interest-rates-september-meeting-2017-9  accessed on October 23, 2017.
[4] https://asia.nikkei.com/magazine/20170914/Business/China-aims-for-dollar-free-oil-trade?page=2  accessed on October 23, 2017.

The post Views on Fixed Income: Fixed Income as Ingredient, Not Total Solution (Part Three) appeared first on AWM.

Bond yields are not simply priced in a vacuum.

Investors (usually) expect to collect some sort of coupon above the rate of inflation.  They want to protect their purchasing power.  However, as the chart below reveals, at times bond yields can fall below the rate of consumer price inflation.  Indeed, 10-year bond yields were actually below the rate of inflation until just before President Trump’s election.

Inflation is stable to increasing.

If we get economic stimulus and greater confidence on prospects for future economic growth, bond yields could rise.  When bond yields rise, bond investors suffer a loss on their principal.  Markets force the bonds to price at higher yields.

What happens if bond yields increase significantly in real purchasing power terms?  What if they were to rise 1% or 2%?  How could that impact returns on other investments such as stocks?

History over the last 55 years suggests that stocks in many, but not all, cases have posted positive annual returns when real bond yields have risen 1% or even 2% in the past year.  In other words, bond investments have tended to lose money, yet stocks in many cases were able to increase.

Over the last 55 years, stocks, as measured by the S&P 500, fared well even when real 10-year bond yields increased by 1% or more.  In fact, stocks appreciated more frequently and at higher rates under a moderate rise in interest rates.

Stocks still posted positive annual gains in most months when real bond yields rose an even more dramatic 2%.  However, stock returns on larger increases of 2% or more in real interest rates were muted and occurred less frequently than when interest rates rose less dramatically.

In other words, in a scenario of rising real bond yields, bond investors potentially have more to be concerned about than stock investors.  That does not imply, though, that stocks will necessarily do so well in the future, nor should investors discard all of their bond investments.  What it might suggest, though, is that investors should consider investing in diversified portfolios that include an appropriate mix of different investments.

Schedule appointment

The post Views on Fixed Income: Stocks, Bonds, and Inflation (Part Two) appeared first on AWM.

Let’s take a walk down memory lane.  Where were you 10 years ago at this time?

Do you remember when banks used to offer 4% rates on money market accounts?  Today, bank depositors would be fortunate to get 1%.

Since the eve of the Great Recession in 2007, US Treasury yields have declined considerably from over 5% to levels around 2.4% currently.  Fears of permanent economic damage in terms of lower growth and deflation along with strong intervention via purchases of government bonds by the Federal Reserve have pushed long-term Treasury bond yields down to historically low levels.

Bonds have had a tremendous run with yields falling and prices strongly rallying since their peak in 1981.  Will the good times keep on rolling?  Or are we due for a reversion to the mean?

The strength of the US economy (or lack thereof) is one factor that could determine the direction of future bond yields.  Another factor is inflation, the rate at which prices on the goods and services consumers and businesses purchase increases.

Schedule appointment

The post Views on Fixed Income: Simple History in Pictures (Part One) appeared first on AWM.