Investors Drive as if the Rear-View Mirror Is Their Only Guide

Occasionally, it’s good to rant. Ok, maybe not so much, but it can make you feel better in the moment. Ranting can also be dangerous because nobody wants to hear: “I told you so.” In the investment world, this seems to happen all the time. Everyone is an expert in the moment, never mind that they have no idea what the expert originally said. Let’s just say “accountability” is lacking in the investment media and advice world.

 

 

If you have been reading this newsletter for a while, you know that there were several previous letters advising against buying 10-year Treasury bonds when they were yielding less than 2%. They weren’t exactly a safe place to park money when yields were so low. The entire ‘risk on risk off’ phenomenon was ludicrous. A 10-year bond that only yields 1% has its own risk, and the math isn’t pretty. Investors have now discovered the dark side of trying to add an “extra” .5% (or less) to their income by stretching maturities. Was it really a surprise when the Wall Street Journal published an article last week titled: “A Classic Strategy for Investors Falls Apart”? When an investment has little value embedded in it, there is almost always more risk than reward.

 

 

The 60/40 strategy, as the Wall Street Journal suggests, has been a staple for more conservative investors and retirees for almost 100 years. It has been seen as the near-perfect solution for growth without the excessive volatility of the stock market. Just invest 60% of your funds in the stock market and the remaining 40% in bonds. When stocks decline, the bond portion of the portfolio helps stabilize your account. It has been a proven strategy with decent returns since 1937 but then came 2022. The Journal describes how investors were blindsided by how much their portfolios declined when they were expecting a conservative strategy.

 

 

If an investment performs well for an extended period, investors seem to interpret the trend as a predictor of the future. The future will just be more of the same. Treasuries have no risk of default, but they do have price risk. When interest rates decline to near zero, there is a lot of room for prices to fall. In July 2020, a 10-year Treasury note yield reached a low of 0.5%. At that yield, something bad was bound to happen before your bond reached its maturity, and it did, prices tanked (yields went up). Today that bond is worth about 20% less than what it was in 2020. Fortunately, those investors will get their money back in 2030 when the note matures. However, your minuscule interest payment will never compensate you for your loss, 0.5% only adds up to 5% in 10 years. This scenario is what seemed to catch the WSJ’s interviewees off guard. Not only were their stock portfolios down 20% or more, so were their bond investments. The road in bond land had been smooth and straight for several years leading up to 2022, so, why should investors expect anything different? If you don’t want something bad to happen it is not a good idea to drive using the rear-view mirror as your guide. The world and the economy are always changing. The investors that were interviewed knew the car had hit something but had no idea what. If you don’t know what you own, it is only a matter of time before the market teaches you. The rant is not that it was obvious bonds were going to decline, but that the article implied that once again ordinary investors are victims of market losses. How could they have known? A 60/40 portfolio has been a big negative surprise this year, but it was just math.

 

 

With yields currently at 3.75% for 10-year Treasuries, they are not screaming buys, but they do offer some value. If you purchase a Treasury note at its current yield of 3.75% today, and interest rates immediately rise to 5% after you purchase the note, its price will decline by 10%. That means that it now takes less than three years to break even instead of 10 years for those who bought in 2020. The 60/40 portfolio is not dead – it is starting to make sense again.

 

 

It almost always comes back to cash flow. There are exceptions like art, gold, vintage Ferraris, as well as other collectibles, but to us common people, a predictable cash flow is what ultimately matters as investors. The faster it can compound – the better. To illustrate this, for example, PepsiCo reached an all-time high today. It pays a 2.5% dividend that is 20% higher than it was in 2020 (not all things have fallen apart). A growing cash flow that is sustainable can cover a multitude of investing sins. What falls apart for one person might be another person’s opportunity. Don’t drive looking in the rear-view mirror.

 

Observations On The Market No.377