June 21, 2021: Stocks Are Not Replacement Of Bonds | Better Financial Future -- MyPlanIQ

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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 Thursday July 1, 2021.

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.

Stocks Are Not Replacement Of Bonds

We received several emails after we published last week’s newsletter Outperform The Best Performing PIMCO Income Bond Fund. Frankly, we were surprised by these emails and would like to comment on them.

Those little upside but lot of downside bonds

One user said the following:

“Your newsletter is all fine but who needs those little upside but lot of downside bonds right now? As you said, bonds offer ultra low yields. Stocks have done a wonder for the past 10 years and I expect more to come as the current policies are all for TINA …”

For those who aren’t familiar, TINA means ‘There Is No Alternative’ for stocks.

Another user just simply sent us the past returns of ETF USMV (iShares MSCI USA Minimum Volatility) from Morningstar. We show the following table for our discussion purpose:

Portfolio Performance Comparison (as of 6/18/2021):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR
Schwab Total Return Bond	3.5%	8.4%	8.1%	6.8%
MPIQ ETF Fixed Income	1.8%	6.5%	8.3%	6.1%
USMV (iShares MSCI USA Minimum Volatility)	7.6%	21.4%	13.0%	12.3%

So here we are, for the past 5 years, $10k invested in USMV would have grown to 17.8k while our Schwab Total Return Bond portfolio would be $13.9k. Of course, who needs bonds, right?

Is it different this time?

Though many people would agree that bonds should be part of one’s portfolio, few are excited about the futures of bonds: not only the interest rates are extremely low right now, recent inflation numbers are actually very discouraging: the latest US inflation rate is 4.99%. It’s much higher than 2%, the normal inflation rate expected by the Federal Reserve. We all know that US government has pumped (and will continue to do so under the current administration) trillions of dollars to the economy. This much of money will eventually come back to haunt us, meaning causing higher inflation.

It’s also understandable that the current stock bull market has run for over 12 years and counting (though there was a brief and steep one month drop in 2020, stocks recovered so fast that many people didn’t treat it as a bear market). This is the longest bull market in history!. Stocks have been only going up these days for so long.

Because of the unprecedented strong interventions governments have adopted (and are determined to do so in the future), the TINA acronym was born and stocks have seemed to be invincible: a dip is met with a flurry of buying to immediately push stocks back up or met with a very loose central bank’s monetary policy (like quantitative easing and/or interest rate cut) and/or government’s fiscal stimulus. This government and central bank support acts like a giant put option to put a floor on risk assets such as stocks. Either way, it does seem it’s a surefire way to get rich from stocks.

These days, there are so many stories in reddit.com on people who became a millionaire from trading stocks (see this, for example). People are all over talking about stocks like Game Stop, AMC, Tesla, Zoom and then there are these cryptocurrencies like Bitcoin, Ether, … What a frenzy on stocks!

It does look like it is different this time!

If asked, many people would agree that stocks cannot rise forever. This is obviously true as, again, majority of people do know things cannot go on in a straight line up forever. So in this sense, this time is really no different!

But then why do they think differently?

That’s because psychologically, when you see people around you, older ones and younger ones, are making so much money from stock market, it’s hard not to be FOMO (Fear Of Missing Out). Greed and fear are builtin characters in humans. Nothing to be shame or denial of them.

We saw the same movie before 2000’s internet high, saw it again in 2007 before the great recession. So this time is really no different.

The questions are really when the big correction will come and how long it will last. But unfortunately, no one knows.

Why bonds?

Well, it looks like it’s a good time to revisit the basic concepts of diversification and asset allocation.

In general, even in the absence of tactical or dynamic asset allocation, we need to know:

Bonds are an important diversifier for a portfolio. A portfolio with only stocks or stock funds can suffer from a steep loss. Even assuming you only invest in solid and diversified stock funds like S&P 500 index fund (VFINX or SPY), these funds can suffer from a huge loss (a 30%-50% loss is just some run of mill correction. Remember 2008?). Unfortunately, such a loss can last from several months to several years. We even believe that a future correction can not only be very steep but it can last for many years from 5 to 10 years (see for example, John Hussman’s excellent writeups). There is no reason we will not see one in the future. When that comes, many people just can’t sit it out for a long time and they often bail out of stocks at a worst time. You have to imagine and simulate this to understand the pain. It’s very different to just merely say I can ignore such a big loss. We have seen this during the 2000 and 2008 bear markets. There are reasons to believe this will happen again when the big one hits.
When stocks suffer from a great loss, bond prices can rise to offset or hedge the stock loss. Of course, this is not always true. For example, it’s likely that if the current inflation persists, both stocks and bonds will fall. On the other hand, it’s also likely (in fact, subjectively, we believe more likely) that we will see the current growth falters once the stimulus is removed. In this deflation scenario, believe or not, bond prices will likely go up (as bond yields or interest rates will come even further down from the current already low levels). This portion of a portfolio will certainly help to offset loss.
As we have written so many times, stocks are at some valuation levels that are the highest in history. It’s really reckless to just bet on stocks without taking this into account. History has proved that stocks often overshoot a lot and then undershoot a lot also. It will happen for sure. We just don’t know when.

Of course, we can only reason about the above likely scenarios in the future. So nothing is set in stone. But that’s precisely why we need multiple assets such as stocks and bonds to diversify and hedge to each other.

Finally, if you are adopt a tactical asset allocation such as our Asset Allocation Composite (AAC) or See our investment methodology, it’s still important to allocate some portion to bonds as it’s still likely that stock markets can suffer some violent and sudden loss like the Black Monday in 1987. Furthermore, a good bond portfolio can be very powerful in the event of stock weakness.

Who said bonds are low returns?

If you extend the above comparison between USMV and our bond portfolios, you’ll be very surprised to see that from 2001 to present, the all mighty S&P 500 index fund (VFINX) actually underperformed our Schwab Total Return Bond portfolio:

This is stunning but actually understandable: stocks overshot so much in 2000 such that it took more than 11 years to finally surpass its level in 2000. On the other hand, our bond portfolio can switch between aggressive bond funds (that have more exposure to risky bonds such as high yield bonds) and those that have more exposure in ultra safe Treasury funds. Utilizing pockets of opportunities in various periods can actually deliver a very reasonable return. In our Schwab Total Return Bond case, it averaged 8.6% annually since 1/1/2001!

We are now in a similar (in fact might be even worse) situation so it’s not unreasonable to see that in the coming decade or longer, stocks will again lag behind a good dynamic bond fund portfolio like those on our Income Investors page.

Market Overview

Stocks took a small dive last week as investors seemed to be confused with inflation, slowing growth or just yet another value to growth rotation, after the Federal Reserve’s open meeting in last week. There are all sorts of opinions on inflation projection. Nevertheless, it does give a feel that markets are not as robust as one would wish.

We are again cautiously optimistic and reiterate 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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