We Are Certainly Living in Interesting Times in the Markets
Last month I wrote about the plethora of bonds in the world yielding less than zero. In other words, lenders are actually paying borrowers to borrow money. I’m guessing that this has happened on a small scale previously – I believe treasury bills briefly had negative yields during the deflation of The Great Depression – but never before to the tune of trillions of dollars. Moreover, it’s astounding in a world where the United States has its lowest unemployment in a half century (Though to be clear, interest rates in the U.S. are currently quite low but not negative … yet). So how has this impacted markets and investing?
Buying Stocks for Income and Bonds for Appreciation
Stocks yield more than bonds!
With last month’s frantic bond buying around the world, many new low interest rate records were set. In the U.S., our 30-year bond hit a low near 1.9%, its first ever dip below 2%. While it has since backed up to a current level of 2.1%, that new low was profound because it briefly traded for a lower yield than the (dividend) yield of the S&P 500. Just think what that means. At that point, we could choose between investing in a treasury and guaranteeing ourselves a 1.9% annual return over the next 30 years or we could invest in the S&P 500 index (via an index fund/ETF) and become owners of 500 of the biggest, best companies in the world and receive a bit more in yield. We’d be getting paid to participate in the inevitable appreciation of these companies over the next three decades (albeit we’d have to stoically sit through the unavoidable, and always temporary, declines while receiving our dividends). While it is true that some companies in the index can and will cut their dividends, I’d bet money that over 30 years dividends of the index as a whole will go up – quite considerably in fact! The choice seems easy to me.
Why buy bonds with low or negative yields? Appreciation?
Over the past few months, negative yielding bonds in Europe and Japan continued their descent plumbing unfathomable rates. Even with September’s bounce in yields, the rates on 10-year bonds are still stunning:
- Japan: -0.2%
- Germany: -0.6%
- Switzerland: -0.9%
Is this a “greater fool” scenario? Theoretically, one reason to buy a bond yielding say -0.5% is that you will be able to profit later by selling it at a higher price. Since bond prices and yields move inversely, this means that you hope to sell at a more negative yield of say -0.75%. While the mood that engenders these purchases and pessimism inherent seems the polar opposite of the euphoric optimism of the dot-com bubble in 2000, there is a rhyming similarity to me. Investors are making purchases – in 2000 of companies that did not even have sales yet and in 2019 of bonds with guaranteed losses when held to maturity – not because the fundamentals dictate. Is this a bond bubble that should be avoided at all costs? I really don’t know if it could be classified as a bubble, but I really would not want to own a long-term bond with a locked-in negative return whenever yields flip back to positive. Any hoped-for appreciation could turn into significant depreciation.
What to do?
Have realistic expectations and diversify. We are in the midst of the longest bull market in U.S. stocks in history. Furthermore the secular decline in interest rates is approaching four decades. Arguably, these markets are fully priced, or in some cases, overpriced. Nonetheless, we do not know how long these trends will continue and there do still remain various pockets – particularly international stocks – that have not really participated yet. We continue to recommend a broadly diversified portfolio of stocks and bonds. It is important, however, not to get out on a limb. We suggest spreading your equities outside of just U.S. large companies into smaller companies, international stocks, and real estate companies. On the bond side, we recommend keeping an eye on duration and not buying very long-dated bonds. In other words, stick to your long-term allocation strategy and continue to periodically rebalance back to your targets. Try not to let this topsy-turvy world throw you out of your plan.