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 March 1, 2022. 

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.

Inflation, Interest Rates And Fixed Income Investments

In this newsletter, we first look at current inflation and interest rates. We then proceed to review our fixed income portfolio and offer some observations. 

Hot inflation numbers

Inflation is perhaps one of the most important factors that affect underlying economies and thus stock and bond prices. Inflation is usually gauged by so called CPI (Consumer Price Index). Recent CPI numbers have been red hot: the 12-month annual CPI ending January is 7.5%, while the December 2021’s number is 7.0%: 

We are now seeing CPI is reaching 1982’s level. The above chart clearly shows it breaks out of the multi-decades’ low range. 

We also need to be aware that the rapid rise happens in the following setting:

  • The Covid pandemic whose seriousness hasn’t been seen since 1918 Spanish flu, more than 100 years ago. 
  • The ultra loose monetary policies that are reflected with ultra low interest rates (close to zero) and quantitative easing (i.e. the Federal Reserve bank’s bond purchase). 
  • The strong fiscal stimulus measures such as the pandemic related stimulus and relief. Trillions of dollars have been injected to the system. 

Whether the inflation is ‘transitory’ is subject to endless debates. At the moment, we are seeing the CPI has been rising almost non-stop for the past 12 months. The ‘transitory’ camp attributes the rapid rise to supply-limit caused by the Covid. The other camp would state that the rise is also long overdue because of the ultra loose monetary and fiscal policies. 

Regardless, we do want to quote what economist David Rosenberg pointed out in the following:

So it’s possible that once we emerge out of the pandemic and the supply chain issues are resolved, the CPI might be able to fall back down to a more normal level. Of course, this hinges on how fast and to what degree the issues are resolved. 

Meanwhile, we are seeing the economy is slowing down as mentioned in the previous newsletter: the Atlanta Fed’s GDPNow  predicts 0.7% GDP for Q1 2022. That’s certainly a very low level, on the edge of slipping to a negative territory. 

Interest rates and yield curve

Interest rates are all over the place: both short term and long term interest rates are jumping, though at different speeds. We are seeing the following Treasury yields for various maturities: 

Note that the 7-Year Treasury yield is now the same as 10 Year’s. So bond investors are essentially saying they believe interest rates after 7 years  will be the flat or lower. On the other hand, the so called yield curve, i.e. the difference between 10 year Treasury notes’s yield and 2 year Treasury’s has been declining: 

Again, when a long term bond (such as 10 years) yield is lower than that of a short term bond (such as 2 year), it indicates that investors are pessimistic on the future inflation. It’s pointed out that a negative yield curve in the above has always preceded a recession for the past 7 recessions. We can see the yield curve has declined since last April and it’s getting closer to 0 (at the moment, 0.4%). 

The above CPI/inflation numbers and interest rates are putting the central bank to a dilemma: they have to be very careful to juggle between tightening and loosening. Raising interest rates (and also removing bond purchase, so called quantitative tightening) too fast might derail the economy. On the other hand, doing too little and too slow to act might make inflation out of control. Indeed, the rapidly rising long term (10 year to 30 year) bond yields have now materially affected home buying because of rising mortgage rates, However, investors also need to be aware that the central bank can’t directly control long term bond yields which are mostly decided by the bond market. So simply pinning hope to policy makers might not get what one wishes for. 

At any rate, we are seeing markets are at a cross road that can easily lead to markedly different outcomes. 

Fixed income investment portfolios

Our fixed income bond investment portfolios have done reasonably well, although the ETF one has been somewhat affected year to date (YTD) due to its previous exposure in municipal high yield bond fund. 

Portfolio Performance Comparison (as of 2/11/2022):
Ticker/Portfolio Name YTD
1Yr AR 3Yr AR 5Yr AR 10Yr AR
MPIQ ETF Fixed Income -4.4% -2.1% 6.3% 5.2%  
Schwab Total Return Bond -2.9% -1.6% 6.6% 5.3% 5.6%
TOTL (SPDR® DoubleLine Total Return Tact ETF) -2.2% -2.1% 2.4% 2.2%  
BOND (PIMCO Total Return Active ETF) -3.3% -2.8% 3.8% 3.3%  
BND (Vanguard Total Bond Market ETF) -3.2% -3.5% 3.4% 3.0% 2.5%

5 Year Return Chart

The portfolios have done way better than bond index fund BND for the past 1, 3 and 5 years (and 10 and 15 years for Schwab portfolio that has much longer history). 

We want to point out that the above total return bond fund (ETFs or mutual funds) based portfolios don’t use short term bond funds as candidate funds. The rationale behind this is that the portfolios are for fixed income investments that have longer than 3 year (2 year is minimum) time frames.The portfolios would temporarily switch to intermediate Treasury bond fund or cash if credit markets are in distress and/or interest rates are under great pressure. At the moment, we are close but not yet reaching an inflection point. 

Based on the above discussion, we believe that both bonds and stocks are in a capricious situation. We expect the portfolios will experience higher volatility in coming months. However, it also comes with some good tactical opportunities as often markets will over correct (thus creating a good re-entry point) and recover. To some extent, it’s a better situation to finally start to get over a long overdue correction or downturn than sitting in an extremely low return and highly priced environment that will eventually correct. 

Market Overview

Earnings wise, with 72% of S&P 500 companies reporting actual results by last Friday, the blended Q4 2021 earnings growth for S&P 500 companies was 30.3%, continuing the streak of positive surprises (30.3%, 24.3% two weeks ago, 21.8% on 1/13 and 21.4% on 12/31/2021) (see FactSet). However, earnings guidance for Q1 2022 is not rosy: % of companies issuing negative guidance was above average as companies mention that inflation is one of the main factors to reduce their earings. This certainly doesn’t bode well with nose bleeding stock valuation. No wonder growth companies stock prices have fallen hard recently. One can expect that this earnings growth slowdown, taken together with a rising interest rates, will very likely to seriously affect stock prices. 

Market internals are also becoming more negative. In fact, the percent of stocks in Nasdaq index that are above their 200 day moving averages is now 19.58%, a level only seen in a bear market (like in March 2020):

The same metrics in other indexes such as NYSE and S&P 500 are all at levels pointing to a big correction or bear market, though they are not as negative as the Nasdaq one. Indexes have corrected double digits, with Nasdaq index leading the way to an about 15% loss.  Markets are at an interim state on the way to a bear market. Of course, it’s still possible for them to recover back and it’s still too early to tell. 

In light of the current volatile markets, we call for caution and urge investors to review their risk exposure (i.e. stock exposure). You want to prepare your investments to a level you are comfortable with, especially for strategic allocation in order to ride out a possible serious bear market. We also advocate the following practice:

  • 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 is still extremely high by historical standard. 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 emphasize that 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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