July 18, 2022: Fixed Income Is Becoming An Alternative

Jul 19, 2022 | Feature, Newsletter

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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 Monday August 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.

Fixed Income Is Becoming An Alternative

Well, after a long period of TINA: There Is No Alternative (to stocks) and an unprecedented period of loss year to date for bonds, fixed income or at least some part of fixed income (i.e. short term Treasury bills or bonds) finally started to become an alternative (to stocks). 

High prices are going to stay for a while

It seems that many (including some experts) have a misconception that the recent price rise among food, consumer goods and energy can rapidly decline once interest rates are raised enough. The reason behind this is that interest rate hike by central banks will slow down demand and that in turn will pull down prices drastically. We beg to differ. To quote what we wrote in our last newsletter: 

“Interest rate hikes done by the Federal Reserve can only slow down demand and it doesn’t affect supply side very much, at least initially. The feedback loop might be too long for prices to come down. So it’s very likely that we will see a period of high prices and low growth (so called stagflation) that will still force the Fed to continue to raise interest rates and tighten financial conditions that will further dampen growth to the extent that it might overshoot. “

As we received some questions from our subscribers on the above, we want to expound the ‘feedback loop’ part a bit here. Basically, when interest rates rise, a distributor, a manufacturer or a service provider (like a dental office) is pinched in their operational finance (such as a short term loan for a manufacturer to get parts or equipment lease in a dental office) as higher loan interests increase payment cost. Now even if they start to notice some slow demand as consumer side also get pinched by higher interests, they are in general slow to adjust prices (human inertia and hope) in order to maintain their profit (if any). In fact, lowering prices not only hurts gross profit but since unit demand is down, they are squeezed from both sides. This process will of course stay for several months at least. Similarly it will take some time for an organization with hundreds or more workers to start to freeze hiring, freeze wages and layoff people: think about the planning, budgeting, convincing, HR policies etc.. The change can take some time and prices will later on catch up. The gradual process will only start to accelerate if the weakness becomes wide spread and eventually reaches an inflection point. 

We should add that the above analysis doesn’t apply to energy prices we are seeing everyday. Crude oil and natural gas prices are notoriously affected by speculators in a short term. However, even if the Ukraine/Russian war ends immediately (which is not likely as it seems at the moment), we see that energy prices will be high as the traditional energy infrastructure has been under invested in favor of green energy (who would want to invest in more oil rigs or refinery if the fossil oil is declared to be dead in 10 years or so?) for a while, assuming economy doesn’t drastically deteriorate. 

At the moment, we are seeing the process just gets started or maybe at most in third inning (?). At any rate, it will be a while for high prices to come down. We are likely in a stagflation (slow growth with high inflation) for some time. The central bank is in a bind: higher rates -> recession and low rates –> high inflation (not acceptable to many) and eventually recession. In between these two scenarios, there is an unlikely (but still possible) outcome, the so called ‘soft landing’ where inflation comes down while economy slows down just right without much damage. 

Recent economy developments

We are seeing more of the same this month reports (for last month): industrial output still stays high, unemployment rate stays very low (3.6%) and a red hot CPI 9.1%. In addition, retail sales was actually better than the expectation but it’s still lower year over year: 

These data support the above argument/explanation: the process to reach a resolution (a recession or a ‘soft landing’) will take a while. However, as we said in our last newsletters, we believe the unemployment rate will certainly rise and the industrial production will come down in the coming months because of rising interest rate-induced higher cost or slow demand will eventually trickle down to employment and other economic activities. 

Ultra short term Treasury bonds as alternative

If we continue our analysis, we can see that both outcomes: a slow down then recession or high inflation and stagnated growth will be bad for stocks. Of course, as we wrote in our previous newsletter: 

“Though the current 20% S&P 500 stock loss might seem to be high, we are reminded that so far, its loss is really due to interest rate rise or so called PE multiple compression (compared with bond yields, now stocks become less attractive thus their prices over earnings multiples need to come down). So far, we haven’t seen much from company earnings slowdown reports. However, with a Federal Reserve Bank that’s determined to slow down demand (and it’s succeeding), there will be no surprise that we are going to see more weak earning reports from now on. 

In a word, it’s highly likely the current market weakness in stocks will continue. “

The only risk for the above assessment is whether the future earnings multiple compression has been priced in current stock prices. Given the still very much elevated stock valuation (S&P 500 CAPE 10 is only lower than the peak of 2000 and higher than all other periods), the odds are low for stocks to stay at this level if earnings are materially lower. 

Even though interest rates might not continue to rise for too long as the economy has experienced some noticeable slowdown, there is still a big risk  that inflation can continue to be high for quite some time. On the other hand, notice that corporate credit risk is still high (as recession risk is high). Thus corporate bonds are still bad for now. Naturally this leads to a probably good bet on short term Treasury bills or notes (one year or shorter maturity). Though this might not yield a lot, but as interest rates are rising fast and now one can get a Treasury bill that matures within a year with as high as 3% interest: (see Vanguard’s info here):

The stellar outperformance of our fixed income portfolios continues

We now briefly look at our fixed income portfolios (see Income Investors page for more details): 

Portfolio Performance Comparison (as of 7/15/2022):
Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR
MPIQ ETF Fixed Income -5.8% -6.2% 3.6% 4.6%    
Schwab Total Return Bond -1.8% -2.7% 5.2% 4.8% 5.4% 6.9%
DLTNX (DoubleLine Total Return Bond N) -6.8% -6.4% -0.3% 1.1% 2.2%  
PONAX (PIMCO Income A) -7.5% -5.8% 1.0% 2.3% 4.9% 6.7%
PTTAX (PIMCO Total Return A) -11.4% -11.9% -1.0% 0.7% 1.4% 3.9%
LSBRX (Loomis Sayles Bond Retail) -11.0% -10.1% -1.0% -0.0% 2.4% 3.8%
MWTRX (Metropolitan West Total Return Bond M) -10.4% -10.8% -0.3% 1.2% 2.1% 4.2%
FTBFX (Fidelity Total Bond) -9.7% -9.4% 0.7% 1.8% 2.3% 4.4%
VBMFX (Vanguard Total Bond Market Index Inv) -9.8% -10.4% -0.7% 0.9% 1.4% 3.2%

Five-year chart:

We want to point out the following:

  • This year, though they incurred some loss so far, our portfolios are much less than other funds. 
  • Both our total return bond ETF and mutual fund based portfolios have returned so much higher: for the past 5 years, for example, they outperformed at least 2.3% over the best mutual fund performer (PIMCO Income PONAX) annually. They are at least 3.7% better annually than total bond market index fund (VBMFX) in this period. 
  • What’s more, they had only half of maximum loss from a peak to its subsequent trough (drawdown) compared with VBMFX. 
  • Who said bond market is efficient? The total return bond funds listed above have consistently outperformed VBMFX by some meaningful margins for the past 10 and 15 years. 

As we have pointed out several times in the past, we believe fixed income investing in the coming decade will yield more significant returns and they will become more relevant after some big valuation reset. In fact, this was evident in the high inflation period in 1970s and 1980s when fixed income returned better than stocks (see this for details):

Market Overview

Now we are entering earnings report period for last quarter, analysts expected this quarter’s earnings growth will be 4% (see Factset). If this is indeed the case, it would mean last quarter’s real earnings growth (after subtracting inflation) would be negative. In an era where inflation is high, one needs to change the usual ‘inflation is neglectable” attitude which they have been so used to for more than 40 years. At any rate, as we pointed out in the above, it’s increasingly possible for investors to have other alternatives (bonds) to stocks to consider. 

Stock price wise, as of today, S&P 500 recovered about 4.4% from its June 16 low. In general, a bear market can experience multiple 10% or higher bounces in its way down. Market internals haven’t improved much. Even though growth stocks have corrected as much as 31% from its high, S&P 500 corrected as much as 20% while large cap value stocks only corrected 13% or so:

Given high valuation, a hostile interest rate and monetary environment, odds are high for markets to continue to weaken. (for those who love reading a bit more on this subject, we highly recommend Dr. Hussman’s commentaries.). Of course, our strategies are tactical and we will respond according to market and economic conditions. 

We again call for patience and ask investors to stay 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. However, it is still high 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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