August 31, 2020: Investing In An Ultra-Low Return Environment

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

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Tuesday September 1, 2020.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month.

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.

Investing In An Ultra-Low Return Environment

As stocks and bonds have had spectacular returns even amid the scary COVID-19 pandemic, it becomes even more imperative for us to examine the current investment environment. Unfortunately, for a long term investor, the picture is not rosy, in fact, it’s depressing.

Stock and bond returns for the coming decade

Stocks are making new highs almost non-stop. It does seem that “this time is different”: with the Federal Reserve behind the market (to do whatever it needs to support it), the idea of there is risk in stock investing is becoming more and more remote.

We have claimed numerous times that it’s much easier and more accurate to estimate stock returns in a long term. The long term here, however, should be again a truly long one: 10 years or even longer.

One of the simple yet reliable indicators is the ratio of Total Stock Market Cap to GNP (Gross National Product), the one Buffett famously quoted near year 2000. He stated:

“The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment”.

“If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire”.

Well, right now, by our own measure, this ratio sits around 200:

Many other more sophisticated metrics have also indicated an extreme valuation situation right now. For example, Dr. Hussman has estimated, based on his own improved indicator, that a portfolio of 60/30/10 stocks, Treasury bonds and Treasury Bills will have negative annualized nominal return for the next 12 years.

As usual, you will hear some of counter arguments that might sound reasonable. One could say that ‘this time is truly different as the Federal Reserve has openly pledged to support public bond markets using whatever it takes’. In this case, there will be a floor on how far stocks can fall.

This might make sense. However, even assuming there will be a good floor to support stock prices, this does not imply that stocks will enjoy a historical norm return from here. In the extreme case, stocks will be flat or fluctuate a bit (because of the Fed’s floor) for the next 10 or 12 years. Well, this does not contradict with the low return claim.

Look at the other way, if stocks would continue to enjoy a historical norm 10% annual return for the next 12 years, assuming GNP would also grow at a 2-3% normal annualized rate, the Buffett ratio would become 2*(1.1)^12/(1.03)^12 = 4.4! This would imply the ratio would be more than 4 times of the historical average (1 or 100%).

Using Buffett’s words, stock investors are playing with fire right now!

Of course, as for those who hope that stock prices will meander with little fluctuation in the future, we can look at what happened in Japan — a country that has adopted the ‘whatever it took’ policy to prop up its economy for more than 20 years in an ultra low (sub-zero) interest rate environment:

So it has experienced 3 times that had 50% interim losses for the past 20 years. Nothing is really flat and only little fluctuation here!

As for bonds, given the 10 year Treasury bonds returning 0.7% and 30 year Treasury bonds returning 1.48%, a total bond market index fund such as Vanguard VBMFX will probably return 1-2% annually at best for the next 10 years or so. This again is a very depressing figure.

Active asset allocation and fund selection

As much political incorrect this might sound in the investment community, we believe for the next 10 to 15 years, a pure buy and hold strategic allocation portfolio will not be able to deliver a reasonable return. Of course, for the capital that’s not needed for a long time (say 20 years or beyond), it’s still possible to buy and hold stocks for that long period of time and reap higher returns (but even in this situation, the returns will not be reduced as the capital will probably spend the first 10 years going nowhere).

The future returns thus have to come from dynamically allocating capital to various assets:

Among stocks, value and small cap stocks will probably have higher returns.
Internationally, developed countries’ stocks (European and Japanese) and emerging market stocks will outperform the US.
But bigger returns will come from active rotation among these assets.
Similarly, factor rotation such as those on Advanced Strategies (P Composite Momentum Scoring Factor ETFs, for example) or other active style/sector/industry rotation will hopefully pick up the slack to capture under and overshoots of stocks to deliver better returns.
For bonds, as stated in the previous newsletter, the returns will have to come from active shifting among bond sectors such as foreign bonds, high yield/corporate bonds and long/short term bonds.

We also believe that it will become more critical to make fund selection not only based on a fund’s momentum, but also based on the overall macro macro conditions. In a highly distressed environment, most, if not all, of individual funds will have similar behavior. For example, in the most dire time during the 2008 financial crisis, even prime money market funds (Reserve Prime Money Market fund, to be specific) broke the long held tradition and lost money. Recently, Vanguard decided to shift its flagship Prime Money Market fund’s investments to government backed securities (Treasuries and government agency bills). The news was mostly ignored by investors. To us, we believe this is a serious indication that Vanguard, one of the largest money market fund providers, has decided that it’s not worth the risk to invest in corporate and other ‘less’ safe debts in the current ultra-loose debt market. This is a good reminder to us on the lurking risk.

Market overview

As we are closing out August, our risk assets (stocks) internal indicator is still showing a big divergence. Headline stock indexes such as Nasdaq and S&P 500 have been heavily influenced by a few (6 to 10) stocks:

Small cap stocks, utilities stocks and most stocks in S&P 500 index have not even recovered back from their February highs,

Furthermore, we are now entering September, the worst month for stocks:

Courtesy of Yardeni Research

Subjectively, we believe that the major uncertainty induced by the current pandemic will be more likely resolved in September. If the economy can continue to improve, the current speculation will probably continue for a while. On the other hand, if the second wave of the pandemic occurs and it’s serious enough to affect the economy again or other serious events occur, markets will undershoot again, given the current extended, very overbought condition.

Of course, we shouldn’t rely on our subjective opinion and should follow our strategies instead:

For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation now reached another high. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

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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