60/40 At Record Low Yield

We recently reviewed an interesting analysis of the history of the yield on a 60/40 portfolio going back to 1878. This portfolio is allocated 60% to stocks (equities) represented by the S&P500, and 40% to fixed income (bonds) represented by the 10-year U.S. Treasury bond. “Yield” is a measure in percentage terms of the cash flow generated by the portfolio (from interest and dividend payments) relative to total portfolio assets. It is not the same as total portfolio return, which includes both yield as well as capital appreciation (or loss). A 60% equity, 40% fixed income portfolio has been long-used as a “benchmark” or default allocation for retirement investing.

Here is what is interesting: the median yield on this portfolio going back 134 years is 4.2%. On August 31 of this year, the yield on this portfolio reached a record low of 1.98%. The last peak yield in this portfolio was in 1983 at about 9.8% (interestingly about the same level as the peak in 1932).

Why is this so fascinating?  Because 1) it offers an important historical perspective, and also 2) because it has several important implications for investing looking forward, which include:

§  Bond yields, now at record lows, offer very poor return option currently. They may still be required as a means of preserving capital but at a high opportunity cost.

§  Because bond prices move inversely to interest rates, current low bond yields combined with  declining bond prices when rates go up could result in the forward returns on a passively managed 60/40 portfolio below that of the past ten-years’ actual annualized return of 6.9%.

§  In order to achieve higher portfolio returns, investors may have to incur (and tolerate) higher  risk by increasing their holdings of equities and embracing greater flexibility in asset allocation.

Expected portfolio return is an important element in financial planning.  It has an important bearing on the outcome and probability that one will have enough capital to fund their retirement through life end. The current historic low bond yields are a conundrum. Several ways in which we can work to offset the lower bond returns is through utilization of higher yielding bond “surrogates” such as utility stocks or preferred stocks. There are also options for investing in higher yielding foreign bonds, particularly those of stronger emerging market economies. Also, conservative higher yielding equities, such as telecommunications or certain energy stocks, can also offer yields that can help to improve forward portfolio returns without incurring significantly increased risk. Holding higher-yielding equities can also offer some hedge against inflation as companies can raise dividends on stocks, but cannot raise the interest payment on a bond.

60 Years and Counting

We were encouraged to see recently that John Bogle, the founder of Vanguard Funds, has come out with a new book entitled “The Clash of the Cultures”. Bogle has been in the investment industry for 60 years. He has seen it all, the good and the bad. He was an early advocate of low-cost index fund investing, which was the premise on which he founded Vanguard Funds. It is a good thing for our industry that people like John Bogle and Warren Buffett have lived so long and experienced so much and are willing to share their experience and insights with us.

Bogle’s book is highly critical of the financial services industry, primarily because of what he believes has been a) too great an emphasis on short-term thinking (meaning “trading” or speculating over sound fundamentally-based investing), and b) the industry placing too great an emphasis on its own profit at the expense of the investor. This has come into particularly stark focus in the wake of the events of the past 5-10 years. Some of the investment insights he points out in his book are important:

               

·         Despite the problems our economy is now experiencing, Bogle believes long term investors need to hold stocks to capture growth.

·         The outlook for bonds is abysmal, but alternatives are hard to find.

·         Investors need to have a long-term view and stay the course. Trying to time or second-guess the markets is a losing proposition.

·         Everyone in the industry needs to adopt a fiduciary standard that puts the interests of the client first.

From a financial planning perspective, we could not agree more with Bogle. The abuses of our industry over the past ten years have hurt not only individual investors but the economy as a whole, and while as a nation, we have started to make some progress on addressing these issues, the healing process will take many more years. With respect to investing, we agree with Bogle that diversification and a long-term view are critical elements of successful investing. As financial planners, we believe adequate diversification of client portfolios is a cornerstone of good investing to not only reduce volatility but also capture returns of multiple market sectors. Fundamental research is important not only in identifying attractive investments, but also in maintaining and supporting the fiduciary standard which Bogle advocates: basing decisions on reasoned logic and avoiding speculation. We also believe that time mitigates risk, which supports the importance of long-term investing. Why? Because data on long-term economic trends allows us to place greater confidence in developing a financial plan and investment roadmap and incorporating that confidence into the discipline that a sound financial plan provides.

A “New Paradigm” ?

The Wall Street Journal recently ran an interesting op ed written by Burton Malkiel entitled “Even Amid the Current Turmoil, Stocks Still Beat Bonds”. Malkiel is the Princeton prof who wrote the book “A Random Walk Down Wall Street” and is considered one of the pillars of the Efficient Market Hypothesis (EMH). EMH states that the stock market is completely efficient, discounts all that is known about a stock in the current price, and that it is impossible to outperform the market through trading or investment schemes.

To be sure, EMH has come under question in recent years but Malkiel has been around a long time and is well respected in our industry and I believe his opinions carry some weight. The important points about Malkiel’s article were these:

1.       He believes equities today are more attractive relative to bonds than at any other time in history.

2.       He believes fixed income investments will never earn the returns necessary to meet retirement or pension fund planning objectives.

3.       He believes “the only hope” for generating returns necessary to meet retirement planning goals is to increase investment allocation to equities.

While we agree with Malkiel, the notion of holding more equities at or near retirement flies in the face of a long-held “law” of retirement planning, namely that one should hold a large fixed income allocation at or near retirement. While holding more equities may increase long-term returns, higher equity weightings will result in greater portfolio volatility which increases investment risk.

So for us as financial planners, we are sort of in a “new paradigm”: while increasing equity weightings for retirees may now present a more expedient strategy, the question becomes how do we mitigate the risk of higher volatility which would accompany higher equity exposure? We do this in a number of ways:

§  Make sure client portfolios are adequately diversified both by asset class and market sectors

§  Emphasize income in our investment model as higher portfolio income helps to reduce volatility

§  Take care to understand the risk tolerance of our clients and how this translates to their investments

§  Base investment decisions on fundamental research and reasoned logic

§  Identify and invest in undervalued sector opportunities

§  Make sure all clients have a sound financial plan that keeps them on the proper roadmap particularly with regard to their investments. This reduces the risk of emotionally-driven decisions that can destroy the effectiveness of a sound financial plan.

“It’s All Doom and Gloom……”

I ran into a friend at the gym yesterday morning. He is retired and is one of those types that looks at and worries about his portfolio every day. So he stops me and exclaims “Bob….did you see [xyz morning financial show] this morning?! It’s all doom and gloom ! We’re hosed!....”  Of course, this gentlemen, whose intelligence I respect, is pretty much entirely in cash now and has been for some time.

So why is my friend all in cash? Fear. True, the xyz morning financial show was highlighting all the negatives that morning: Europe, Greece, Spain, fiscal cliff, high unemployment, etc. We agree these are serious issues, but the media always highlights the negative, and why not? Negativity sells, it provokes anxiety that keeps people watching….and that sells commercials (remember, the financial news media is in business to make money selling commercials, not providing quality investment advice).

Now, I am not saying my friend is wrong to be primarily in cash. If he sleeps better at night that is important and he may be correct that it is the end of the world. But we doubt it. A few points we would make with respect to all this:

1.       Recent investor surveys reflect a very low level of bullish sentiment currently, levels that many times in the past have proven to be a bullish contrary indicator for stocks.

2.       Stock valuations are not excessive and many sectors in the market remain attractively valued.

3.       Monetary conditions, namely Federal Reserve policy, remain accommodative, which historically has been positive for stocks.

4.       The U.S. corporate sector, reflected in profit margins and cash flow, is very healthy currently, and corporate earnings are forecast to grow this year and next.

5.       We believe Congress will address the fiscal cliff issue.

6.       We believe Europe will find a way out of its ugly morass.

7.       No question, the general risk environment is higher than normal, but ‘twas ever thus…..there are always risks in investing and no one has a perfect crystal ball, but historically the best time to invest is when there is rampant fear and uncertainty.

So should we all be like my friend and be all in cash now? From a financial planning perspective, we believe there are ways to capture what we believe is an attractive risk/reward for stocks while being able to sleep at night. How?

1.       Have a solid financial plan that provides sound spending, savings, and investment roadmaps.

2.       Diversify your investment holdings in order to capture returns of multiple market sectors and also reduce portfolio volatility.

3.       Establish an asset allocation that allows you to capture the growth opportunity in equities while also reflecting your risk tolerance.

4.       Focus your equity investments on quality, dividend-paying and undervalued sectors of the market.

5.       If you are baffled by the market and are uncomfortable with handling your own investments, seek the advice of a qualified and experienced financial planner or advisor.

Growth vs. Value

Part of our daily research includes reviewing financial news that may impact our firm’s investment strategy. We recently came across an interesting article discussing the current disparity in relative valuation of growth stocks compared with value stocks (the link to the article can be found below). “Value” stocks are generally considered to be lower P/E, lower growth, higher-dividend paying stocks, while “growth” stocks are generally considered to be higher P/E, faster-growing companies that pay little or no dividend. The article notes that valuations for growth stocks are now quite low relative to historic relationship to value stocks (this is also supported by work from some of our other research sources).

So what’s the big deal about the valuation disparity of growth vs. value? Answer: the disparity may provide a strategic investment opportunity in favor of growth. Over the past several years, many investors have been favoring high-dividend, primarily large-cap stocks for obvious reasons: fear of volatility associated with smaller-cap stocks; an alternative to declining bond yields for those seeking income; reduced risk tolerance on the part of many investors. This has resulted in compression in valuations for growth relative to value and, hence, has led to the valuation disparity.

From a financial planning perspective, we advocate a diversified portfolio approach; we can and do adjust our allocations to growth and value based on relative valuations and relative performance; and we also seek the higher risk-adjusted returns. As an example of this, we recently changed our mid-cap equity exposure in favor of growth vs. value in order to capture what we believed is a valuation disparity noted above. Because mid-cap stocks are larger in market cap and, as a group, pay higher dividends than small cap stocks, favoring mid-cap stocks over small caps offers the benefit of both higher portfolio income and reduced portfolio volatility. At the same time, holding a diversified index of mid-cap growth stocks as part of a larger, well-diversified portfolio helps our clients achieve their long-term goals by capturing the return of this sector (which has significantly outperformed the S&P500 over the past 5 years) and thereby targeting a superior risk-adjusted return.

Link to article: http://finance.yahoo.com/video/sponsored-26302475/growth-stocks-are-a-coiled-spring-says-nuveen-s-mullinix-30110011.html#crsl=%252Fvideo%252Fsponsored-26302475%252Fgrowth-stocks-are-a-coiled-spring-says-nuveen-s-mullinix-30110011.html

How Long ?

There has been a lot of talk in the financial media lately about the notion that stocks may be in an “extended trading range” like that of the 1970s. What that means is the market remains essentially flat for an extended period, perhaps a couple of years or longer, while churning up and down within a wide price range. The case for this view is based on the belief in an extended period of very slow economic growth (or no growth) which results in very slow or no growth in corporate earnings.

One big question being asked now is “how long will this trading range environment last”? It is interesting to note that the market, as measured by the S&P500, has more than doubled since March 2009 bear market low. It has done this in three waves accompanied by some rather unnerving corrections. Corrections are normal for the stock market: the median decline for the stock market in any given year over the past 85 years has been about 13.5%. So pullbacks of 5, 10, or 15% are quite normal and do not mean we are in a “trading range”.

There are a number of reasons to believe the “extended trading range” scenario may be too pessimistic. First, we think there will be tremendous pressure on Congress and the President (whoever that is) to take action in 2013 to address the fiscal cliff issue and place the U.S. on a stronger footing financially. We also expect improved clarity on government policy particularly with respect to health care. These actions would provide companies more confidence in forward planning which should improve the pace of hiring in the U.S. Also, the current financial health of large U.S. companies is a factor working in the economy’s favor because of their ample resources available to accelerate investments and hiring under the right conditions.

Whatever your view on the extended trading range question, the strategy should not change from a financial planning perspective. We believe the current environment still calls for investing in diversified, balanced portfolios of high quality stocks and bonds, favoring equities now, and with adequate geographic diversification to capture faster growth of markets outside the U.S. We would also emphasize the importance of sticking with a sound financial plan. While markets will fluctuate as they always do, sticking with a sound plan will 1) keep you on track relative to your investments; 2) help keep you from the temptation of trying to time the market or make emotionally-based decisions that can sink a plan and an investment portfolio; and 3) provide the peace of mind of knowing you have a roadmap which reduces guesswork, conjecture, and flip-flopping on your investment strategy, all of which adds unnecessary stress to your life.

A New Marshall Plan

How long will it take the Europeans to figure it out? Watching the day to day events coming out of Europe is like the drip of water torture. No wonder the financial markets are facing such day-to-day volatility. It is clear what the Eurozone members need to do and do fast: craft a master bailout plan to 1) backstop the government debt of the PIIGS (Portugal, Ireland, Italy, Greece, Spain) and 2) shore up the capital of the healthiest banks and let the weakest banks go. How could this happen ?

Obviously financial resources of all G-20 countries would be required: $3, $4, $5 trillion?? The current Euro bailout facility of about $1.6 trillion is not adequate. The capital is available amongst the G-20 central banks. The new facility would be a larger reserve that would backstop the debt of the PIIGS as a long-term workout plan is implemented. A comprehensive workout plan, including austerity measures, could serve almost as a second Marshall Plan (the first was implemented to re-build a decimated Europe after World War II). A comprehensive plan like this would go a long way to restore confidence in the capital markets. 

Our belief is the Eurozone members will eventually work out a plan that has some of the elements described above, but timing and structure remain highly uncertain. We believe the Europeans understand the gravity of the situation, but of course, political pressures can affect decision-making, timing, and ultimate outcomes. In the meantime, from a financial planning perspective, we continue to advocate investing in a highly diversified portfolio that provides exposure to global growth opportunities and delivers above average income. Both the diversification aspect and higher income component of the portfolio will help to reduce its volatility while providing opportunity for return in a “trading range” environment. While slower growth may be with us for a while longer, appropriate asset allocation and diversification with a tilt towards higher income will help investors weather this slower growth period and be positioned for improved market conditions, which we expect eventually.