January 30, 2023: The Bond Era

Jan 31, 2023 | Feature, Newsletter

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 Wednesday February 1, 2023. 

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.

The Bond Era

As always, investors are mostly attracted to fast changing stock markets. Even though bonds have recovered some for the past several months,  many investors are now turning their attention to stocks.

In this newsletter, we want to remind our readers that in a longer time frame such as the next 10 years, bonds or fixed income might very likely be more attractive. We will also review current cash or short term yields.

Who said bonds are boring

The following chart shows the return comparison among our representative total return bond portfolio Schwab Total Return Bond (see Income Investors for more details), VBMFX (Vanguard Total Bond Market Index Inv), VFINX (S&P 500 Index Investor) and VBINX (Vanguard Balanced 60/40 stock bond Index Inv):

Portfolio Performance Comparison (as of 1/27/2023):
Ticker/Portfolio Name Since 2001 AR YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR
Schwab Total Return Bond 8.1% 3.6% 4.5% 4.7% 5.2% 4.7% 6.8%
VBMFX (Vanguard Total Bond Market Index Inv) 3.6% 2.8% -7.1% -1.9% 1.0% 1.4% 2.7%
VFINX (Vanguard 500 Index Investor) 7.36% 6.1% -3.3% 9.9% 9.2% 12.6% 9.9%
VBINX (Vanguard Balanced Index Inv) 6.6% 5.2% -2.6% 6.5% 6.8% 8.4% 7.6%

Since 2001, our total bond portfolio outperformed both S&P 500 (VFINX) and 60% stocks 40% bond balance fund (VBINX). Furthermore, the bond portfolio did it with a fraction (1/7) of volatility compared with S&P 500 (VFINX).

Even year to date (YTD), with all the talk of bear market ending, the portfolio is not far behind the 60/40 stock/bond index fund.

The 70s and 80s experience

We discussed the possible similarity between the next decade and 70s and 80s in August 1, 2022: What We Can Learn From 1970s And 1980s (and May 9, 2022: The Secular Market Cycle Change). We would like to add the following:

  • 10 year Treasury yield (a representative of interest rates) was also coming from a low base in 60s at a similar level like today’s 10 year Treasury yield:

  • 90 days Treasury bill (T-Bill) interest rate also came out of a very low base in 1960s. In fact, during the World War II and early 50s, the interest hovered from 0% to 1% (see NYU stats for data on T-Bill before 1960):

So today’s situation is not that unprecedented as many have been saying. On the other hand, we all learn that in 70s and 80s, inflation was up and down in some big way, only being stuck at high levels for more than two decades.

What we can say from the above (and from previous newsletters August 1, 2022: What We Can Learn From 1970s And 1980s and May 9, 2022: The Secular Market Cycle Change), an era that favors bonds over stocks might be already on us.

So don’t simply dismiss bonds as a boring asset class.

Cash yields are very attractive

With the Federal Reserve Bank being expected to raise short term interest rate another 0.25% and probably will do another one in March, the cash yield (3 month T-Bill) is extremely attractive: before the rate hike end, buying a floating rate ETF (TFLO or USFR, see previous newsletter November 21, 2022: How To Maximize Your Cash Return for details) that pegs its interest rate to 90 day T-Bill weekly auction rate will guarantee you to get more yields even the rate is raised later. On the other hand, once the rate hike is ended, one can start to buy a longer term Treasury bill or bond, or for cash, just as simply as BIL.

Currently, per Morningstar, for example, USFR’s SEC yield is 4.5%. Here are the Treasury and broker CD yields from Vanguard:

The 4.6% T Bill yield is way better than those measly 0.1% or so interest offered by big banks like JPMorgan Chase and Bank of America. By the way, it was said that JPMorgan earned hundreds of millions dollars profit alone last quarter because of its ultra low sub zero interest paid to its customers!

Market overview

Investors are facing two different scenarios:

  • Earnings recession: Based on Factset, with 29% of S&P 500 companies reporting actual results, the blended year over year earnings growth for last quarter is -5.0%, much lower than -3.2% expected on December 31, 2022. On the other hand, analysts on average still expect 3.4% earnings growth for 2023. This might be too optimistic considering the interest rate that’s now at 4%+, compared with almost 0% in many years before last year. In fact, Bank of America expected a 10% earnings drop or about $200 earnings per share for S&P 500 companies in 2023. Morgan Stanley offered similar prediction. With price earnings multiple being 15 to 17 at most in a typical bear market, S&P 500 price should be around 3000 to 3400. Apparently, current S&P 500 price level (4000+) hasn’t taken this into account.
  • Soft landing and goldilocks: Current market actions indicate that investors are more leaning toward a ‘soft landing’ scenario. In this scenario, inflation comes down just right before high interest rates could tip the economy into a recession. Furthermore, even assuming there is no recession, these investors also expect that earnings growth could resume like before. The trouble here is that even without a recession, the effect of the current and past high interest rates is often lagging several months to a year. Earnings just can’t go back to normal fast enough as interest rates will stay high enough (the most optimistic prediction is 3.5% or so at the year end) to seriously affect earnings. Besides, the Federal Reserve is extremely sensitive to loose financial conditions and wage pressure (which will directly affect inflation). This is a central bank that’s not friendly to rising asset prices until economy slows down significantly.

In our subjective opinion, the best scenario would be a short term goldilocks condition until the high interest rates fully affect the economy like several months later. Investors might be speculative again before that. This won’t last long.

As always, we advocate a risk managed approach and let prevailing market conditions and actions guide us further. We call for staying the course:

  • 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 preferably much longer given the current high valuation. 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 and preferably many more 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 has dropped and now valuation is becoming less hostile. However, it is still not cheap by historical standard. For the moment, we believe it’s prudent to be extra cautious. 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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