Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

For regular SAA and TAA portfolios, the next re-balance will be on Monday, June 22, 2015. You can also find the re-balance calendar for 2014 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Giving Up Bonds? 

As promised in our previous newsletter May 26, 2015: Cash, Bonds and Stocks In A Rising Rate Environment, in this newsletter, we will address the issue whether one should abandon bonds in the current environment. 

It should not be surprising to many that our answer is no, we should not abandon bonds in our asset allocation portfolios.  But what are the reasons?

Let’s first look at this issue from portfolio construction angle. 

Bonds in asset allocation portfolios

Bonds or debt are one of the two most important asset classes for a portfolio. Stocks or equity ownership represent a participation in a business. In a healthy capital market (by healthy capital market, we mean a market that is fair based on economic value delivered by businesses), businesses derive profits from the value they provide to customers. A healthy capital market does not necessarily mean a good economy even though it is easier to make profits in a good economy than in a bad one. In general, in the long term, in aggregate, the profit a business makes should be more than interest derived from savings in banks. Otherwise, entrepreneurs would opt to avoid risk of their capital and their hard work by simply going for cash. The extra profit is so called risk premium an equity owner is entitled to. 

On the other hand, bonds or debts represent lending activities that also reward a lender with higher interests when the lender lends money (or purchases bonds) to an entity to compensate the time risk (interest rate changes over time, so longer term bonds have higher risk to lose their absolute (real) value, thus demand higher interest) and credit risk (money lent to a bad company is riskier than that to a good company, thus demands higher interest payment). Fundamentally, since bonds have the first claim and usually have a fixed time frame to get back their principles, they are considered to be ‘safer’ than stocks. 

In a strategic allocation portfolio, bonds and stocks behave differently, thus reducing portfolio risk over time. In the long term, since both deliver returns above cash or money in a bank, such a portfolio deliver better returns than cash. The key role bonds play in a portfolio is that they act like a stabilizer to stocks when they are under stress. This is the expense one has to pay to get such risk reduction.

In a short or intermediate term (can be as long as 10 years), a balanced portfolio with stocks and bonds can deliver better returns than a pure stock portfolio. For example, consider from year 2000 to 2010, a ten year period, S&P 500 index fund VFINX had an average -1% annual return while Vanguard total bond index fund VBMFX had an average 6.1% annual return!

In a tactical portfolio, bonds represent an important candidate asset that can be fully utilized when stocks are under stress. 

In a word, for a very long term consideration, bonds are an essential asset class for a portfolio. 

Bonds in current environment

The above theory is for portfolios in a long term. One can simply dismiss the above claim because she/he is so certain that we are now in a rising rate environment. In fact, one can claim that we are now at the beginning of a secular rising rate period, similar to that from 1949 to 1982 or 1940 to 1982 (includes a flat period from 1940 to 1949), see the following familiar chart and newsletter May 26, 2015: Cash, Bonds and Stocks In A Rising Rate Environment. So why bother to stick to bonds that surely will lose out in such an environment. 

We refute the claim in the following. 

First of all, even though it is an almost universal belief that interest rates are at the bottom: unless interest rates go to negative, the current zero short term interest rate can not be any lower), it is not all that certain why rates can not linger at such level for a long time. Furthermore, intermediate term and long term interest rates can further go even lower (thus, prices of these bonds go higher) if a depression like scenario unfolds. At the moment, even though economy is doing reasonably well, fundamental structural reforms in the financial sector, manufacturing sector and infrastructure building are still rare and many of the key issues that caused the 2008 financial crisis have remained. The serious import and export (or trade) imbalance derived from the recent globalization still exists. The risk of a depression can not be totally dismissed. As an insurance, bonds should remain as the key element, precisely as what’s stated above. 

Second, assuming interest rates can only go up from here (which is very likely), it is again not unlikely that they (from short term to long term rates) can remain at current levels for a long time before they start to go up more substantially. Historically, the period from 1940 to 1949 is such an example. Japan is another example (that has lasted over more than twenty years and still counting). In such a scenario, bonds will again function as a stabilizer when stocks falter.  In fact, stocks had a back to back negative returns in 1940 and 1941 and then another negative year in 1946 in this period. See the chart below. 

Third, even if we indeed enter a period like 1950’s, a gradual rising rate environment, stocks will still experience its usual violent behavior. For example, from 1950 to 1982, S&P 500 had 9 negative annual returns (out of 32 years), an almost one out of three ratio. Moreover, it had a back to back more than 40% in total loss from 1973 to 1974. There is just no empirical or historical evidence to support that stocks will be a safer bet than bonds in a rising rate environment. 

Finally, let’s not forget at this very moment, stocks are very overvalued based on many long term metrics. It has been estimated that S&P 500 will deliver a zero or negative returns in the coming decade (10 years) (see many weekly commentaries from John Hussman, for example). Regardless, in terms of the magnitude of  possible loss/correction, we believe stocks are in a more capricious situation than bonds right now. 

 What about cash?

Another argument from bond bashers is that instead of going to stocks, bond allocation should be allocated to cash instead. Three arguments against this: first, cash in many brokerages and banks are usually much lower than the ‘cash’ used for many studies. For example, in our studies, we use 90 days Treasury bills to represent cash. However, money market funds in most brokerages usually charge as high as 0.5% expense! We think such brokerage ‘cash’ is almost a rip off. 

Second, even though our results in the previous newsletters indicate that T bonds (10 year Treasury bonds) delivered worse returns than cash from 1950 to 1982, this is only limited to long term bonds. Investing in short term and intermediate term bonds can still deliver better returns than cash in such a period. 

Third, unlike in the 1950 to 1980 period, today we have another new fixed income/bond vehicle to help combat inflation: inflation protected bonds or TIPS. TIPS was introduced in 1990’s and thus their effectiveness has not been truly tested in a rising rate environment. However, it is certainly a direct instrument for  a rising rate environment, so we do hold our hop here. 

Certainly, from all of these, the best way to invest in bonds, in our view, is to invest in a total bond fund upgrade portfolio (see Fixed Income Bond Fund Portfolios or Brokerage portfolio page) whose candidate funds are managed by excellent bond managers. Because of the many uncertainties mentioned above, we feel a dynamic process in bond investing offers more assurance and thus is more appropriate for the coming years. 

Market Overview

At the moment, we are definitely suffering from the summer doldrums: stocks are lack luster and losing their upward momentum while in the meantime, bonds are suffering from raising rate anxiety. In general, momentum across most assets are waning. For now, we will stick to our plan.  

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now.  However, recognizing our deficiency to predict the markets, we will stay on course. 

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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