Swedroe: Fishing For Things To Worry About?

If you must find a reason to worry, try these on for size.

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Reviewed by: Larry Swedroe
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Edited by: Larry Swedroe

There is always a reason for investors to worry about the stock market, be it valuations at historically high levels, economic risks, the risk of inflation or geopolitical risk. That is why there is an equity risk premium, and why, historically, it has been large enough to be called the equity premium puzzle.

I recently noted that the news on the economic front has been just about as good as it gets. In fact, for the first time since before the financial crises, almost all developed and emerging market countries have improving economies, with growth, and estimates of future growth, increasing.

I also noted that the news on the inflation front has been quite benign. Finally, with the recent $1.5 trillion tax cut, and further fiscal stimulus from the agreement on the spending bill reached not long ago to avoid a default on government debt, expectations for U.S. economic growth and corporate earnings reports have been strong.

In fact, most quarterly earnings reports have been coming in at higher than estimates. The latest estimate of operating earnings for the S&P 500 in 2018 is about $155, up from about $132 in 2017, an increase of 15%. Surprisingly, at least to most forecasters, a weaker dollar is helping by increasing the earnings of U.S. multinationals.

Based on the above, I concluded that I did not believe there was anything in the economic data that would have caused a crash in stock markets. I then provided other possible explanations for the recent dip.

Historical Record

Before we go into the main subject of this post, it is worth looking at the historical record on crashes like the one we experienced this month. The recent crash saw the market fall about 10%. Reviewing the data since 1970, and looking only at calendar months, I found seven other months when the U.S. market fell at least 10%. The return over the next quarter averaged 7.9%, and over the next 12 months, it averaged 22.4%—both well above the historical average.

Of course, that’s not a guarantee regarding future returns. Thus, it should not be taken as a buying signal. However, it does show that the winning strategy was to avoid panicked selling, to which many, especially those who assume more risk than they have the ability or willingness to take, succumb.

Turning to the subject of today’s post, as the director of research at Buckingham Strategic Wealth and The BAM Alliance, I’ve been getting questions about whether we could see a bear market in stocks accompanied by a bear market in bonds.

In other words, unlike in 2008, when safe bonds provided strong gains to help offset the huge losses in equities, investors have asked whether that might not be the case in the next bear market. The answer is an affirmative yes—it definitely can happen. However, it’s been so long since it did happen that many of today’s investors either were not alive or were too young to experience the pain.

A Long Time Ago ...

The last year of negative returns to both stocks and bonds occurred 49 years ago, in 1969, when the S&P 500 lost 8.5%, and long-term government bonds lost 5.1% (five-year Treasuries lost just 0.7%). While those losses are not dramatic, consider that, as 1969 began, the Shiller CAPE 10 was about 22. As we entered 2018, it was about 32.

Thus, valuations could fall a lot further if risks increase and investors demand a larger risk premium. The yield then on the long-term Treasury bond was about 6%. Today yields are a lot lower. The result is not only that yields could rise much more, but that the same change in interest rates could lead to a larger drop in bond prices because the duration of a bond with a lower yield is longer (the same change in yields leads to a larger change in price). Thus, it’s important to not be lulled by the relatively small losses that occurred in 1969.

The lack of a recent event, or even one that investors have ever experienced, could lead many to conclude that it is so unlikely to occur again they don’t have to consider the risks and plan for them.

 

Unfortunately, treating the unlikely as impossible can lead investors to take too much risk. And when the unlikely occurs, their plans can fail, or they might engage in panicked selling (which is often difficult to recover from because there is never a green flag that lets you know it’s once again safe to invest). With that in mind, let’s look at what I believe is a scenario that could cause a simultaneous fall in stock and bond prices, and actually has some reasonable probability of occurring.

Before beginning, I have an important caveat. As always, my crystal ball—like all crystal balls—is cloudy. Thus, what follows is not a prediction of what will happen, only the painting of one reasoned scenario that is possible. And if it is possible, the market is already incorporating that information into prices.

However, as of now, it’s only a possibility, one with what are likely very low odds of occurring (otherwise prices would be a lot different). If it were to actually occur, prices would move to reflect that change. Finally, I believe the possibility of this scenario occurring played at least some role in the February correction we experienced.

How It Could Happen

As I mentioned, U.S. economic growth has been accelerating. The Federal Reserve Bank of Philadelphia recently released its First Quarter 2018 Survey of Professional Economists. The forecast for full-year GDP growth was revised upward from 2.5% to 2.8%, with even slightly faster growth expected in the first half of the year. The strengthening of the economy comes at a time when the unemployment rate is already at, or near, what many economists consider full employment. It is forecasted to fall even further, from 4.1% to just 3.8%.

That could easily lead to pressure for wage increases, which in turn could lead to higher inflation, which the market is not expecting (the latest Philly Fed survey forecasts inflation in 2018 at just 2.1%). As another indicator that the market is not expecting inflation to be a problem, the spread between the 10-year nominal bond and the 10-year TIPS is about 2.1%.

This is important to keep in mind, because it’s not whether news is good or bad that drives stock prices. Instead, it is whether the news is better or worse than already expected. Thus, if the market is only expecting 2.1% inflation and it gets 3% (even if 3% is not so bad), it could have a negative impact on bond prices.

Fed Concerns

With the economic recovery continuing, the Federal Reserve has continued to normalize interest rates, reversing its exceptionally easy monetary policy. However, the real federal funds rate still remains negative, as it stands at about 1.5% with inflation of 2%. The market is already expecting (that is, a 50% or greater likelihood) three 25-basis-point increases, which would put the upper limit for the federal funds rate at year-end at 2.25%.

However, if either economic growth were stronger or inflation higher than expected, the Fed would be expected to add at least one more increase, if not more. That would likely put pressure on the entire yield curve (bond prices would fall).

Compounding the problem for the Fed is that it also has to be concerned that the fiscal stimulus from the tax cut (about $1.5 trillion)—and then hundreds of billions more in deficit spending that came with the deal to avoid a government shutdown—could add further stimulus to economic growth and inflation pressure.

Normally, we see fiscal stimulus when we have a weak economy (as in 2008), when the added demand would not impact inflation. Adding that much stimulus when the economy already is strong and unemployment is low could cause concern at the Fed and lead it to lean toward more monetary policy tightening. And the Fed’s new tool already could be giving it cause for concern.

 

The Fed’s New Tool

Economists at the Federal Reserve Bank of New York introduced a new measure of trend inflation in September 2017, the Underlying Inflation Gauge (UIG), meant to complement the current standard measures. To quote the Fed: “The design of the UIG is based on the premise that movements in trend inflation are accompanied by related changes in the trend behavior of other economic and financial series. Consequently, we examine a large data set to identify the common component of other economic and financial series and then focus on the persistent part of the common component.”

The UIG increased slightly from a currently estimated 2.94% in December to 3.00% in January. This is higher than the “prices-only” measure, which has been running at about 2.2%. Again quoting the Fed: “The UIG measures currently estimate trend CPI inflation to be approximately in the 2.2% to 3.0% range” (already above their target of 2%). But, that’s not all.

Supply Problem For Bond Prices

While there could be pressure on the Fed to raise interest rates to slow inflation and prevent the economy from overheating, it would be occurring at the same time the Fed is engaged in unwinding the $3 trillion of bonds it bought in its program of quantitative easing.

That buying increased demand for bonds and drove down yields. This time around, the Fed would be selling those bonds at a time when rates were already rising, putting further pressure on bond prices. But, there’s more.

While this is happening, the Fed also has to finance a now-$1 trillion budget deficit, adding to its borrowing needs. Again, that could put further pressure on interest rates. And don’t forget that, with $20 trillion in debt, rising interest rates themselves create a problem as the cost of financing that debt increases, increasing the deficit. Every 1% increase in rates equals another $200 billion in the cost of financing that debt.

Summing up, we could have strong private-sector-borrowing demand from a robust economy, inflation concerns pushing the yield curve higher, the Fed raising short-term rates at the same time it is unwinding its balance sheet, and increased borrowing demand from the budget deficit further pressuring yields upward. Because stocks compete with bonds, that could put pressure on stock valuations.

Remember, equity valuations are determined not only by earnings, but also by the rate at which investors discount those earnings to arrive at a current value. The higher the risk-free rate (considered to be one-month Treasury bills), the higher the discount rate and the lower stock prices.

In addition, if the Fed is seen to have to raise real rates sufficiently to slow the economy and dampen demand, which would reduce the threat of inflation, the risk premium demanded above the risk-free rate could increase as well. As a result, earnings growth could slow. And that’s how bear markets can happen.

Unfortunately, we are not done yet. The Fed’s policy of holding down interest rates led many investors, especially those who prefer the cash-flow approach to investing (instead of the total return approach), to abandon their safe bond holdings (which were providing almost no return) and buy higher-yielding, riskier assets, be they REITs, MLPs or high-dividend-paying stocks. That worked fine, as all risky assets provided strong returns since 2009.

 

However, cash flows into those assets, along with the strong returns, drove valuations up and yields down. While a stock paying a 3% dividend when a bank deposit is yielding 1% is attractive, it might not seem the same when the dividend yield is 2.5% and the bank deposit is yielding 3%. If risky assets start to fall in price, we could see the tide reverse and a flood of assets come out of those same REITs, MLPs and high-dividend-paying stocks and move back to safer bonds. That could put further pressure on equity prices.

If you aren’t depressed yet, I’ll throw in the president’s stance on trade tariffs. Thankfully, he has been more bark than bite on this one. But if you want a recipe for a stock market crash, a trade war would be a good ingredient to start with.

Where Do You Turn?

What is an investor to do if they are concerned about the possibility of stocks and bonds both providing negative returns? The answer is not to move to cash.

First, as I stated, this scenario is only a possibility, not a certainty. Second, cash provides almost no return. The answer is to invest in other unique sources of risk (other than market beta and term risk) that also provide premiums that are persistent, pervasive, implementable (meaning they survive implementation costs), and have logical explanations for why we should expect them to continue in the future.

At Buckingham Strategic Wealth, we have identified four strategies we believe meet the criteria. They are each unique in that they have little to no correlation to either equity or bond risks. They are alternative (or marketplace) lending (such as the Stone Ridge Alternative Lending Risk Premium Fund (LENDX)); reinsurance (such as the Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX)); the variance risk premium (such as the Stone Ridge All Asset Variance Risk Premium Fund (AVRPX), which sells puts and calls across stocks, bonds, commodities and currencies); and long-short alternative premium funds (such as the AQR Style Premia Alternative Fund Class R6 (QSPRX) and the AQR Alternative Risk Premia Fund (QRPRX)).

Alternative lending funds make prime-quality loans to consumers, small businesses and students. These loans are fully amortizing and relatively short-term (three to five years). Due to the low correlation of the four strategies, we estimate a portfolio of the four would have volatility of only about 5%, similar to that of an intermediate bond portfolio, while providing an expected, forward-looking return of about 7.5%.

Thus, relative to equities, you have similar expected returns with about 25% of the volatility, and, relative to safe bonds, you have similar volatility (though you’d lose the flight-to-quality benefit you receive from high-quality bonds) while getting a much higher expected return and virtually eliminating inflation risk. Either way, you would improve the expected Sharpe ratio of the portfolio.

Because each of these alternatives has little to no exposure to the risks already in traditional stock (market beta) and bond (term or inflation) portfolios, they can improve portfolio efficiency and protect investors from the tail risks of stocks, bonds and even both.

 

Conclusion

Hopefully, as you read this, you kept in mind my caution that I was not making any forecast about what was going to happen, or even what was likely to happen. That said, when designing a plan, we must deal with the fact that investing is always about uncertainty, where we cannot do any better than estimating the odds of an event happening. At least with risk, we know the odds.

That is why it is so critical investors design plans that do not reach for more risk than they have the ability, willingness and need to take risk, and then to stay disciplined. That said, traditional portfolios typically have most, if not all, of their risk in just two risk baskets: the equity risk premium and the term premium (and perhaps the credit premium if investors buy corporate bonds).

Because stocks are so much riskier than bonds, the typical 60% stock/40% bond portfolio has almost 90% of its risk concentrated in equities (something most investors are unaware of). Alternatives such as the ones I mentioned allow investors to access new, unique sources of risk and return, diversifying their portfolios more effectively and providing some protection for stock and bond bear markets.

Kevin Grogan and I have completed work on an updated version of “Reducing the Risk of Black Swans,” which will include in-depth discussions on alternative strategies and how they improve portfolio efficiency and reduce tail risks. The book should be available shortly.

(Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge and AQR funds in constructing client portfolios. I personally have significant investments in each of these strategies via the following funds: LENDX, QSPRX, QRPIX, SRRIX and AVRPX.)

Important Disclosure For Forward-Looking Return Expectation Assumptions

This information includes illustrations of Forward-Looking Return Expectation assumptions with similar risk characteristics for the types of portfolios we design for clients. Forward-Looking Return Expectation assumptions are based on statistical modeling and are therefore hypothetical in nature and do not reflect actual investment results and are not a guarantee of future results. Buckingham makes no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information in this article. The Forward-Looking Return Expectation assumptions and surrounding expectations may differ materially from actual results based on a variety of factors, including but not limited to the actual asset allocation determined to be appropriate for any individual clients, market conditions, economic conditions and the length of time a portfolio is held. Past performance is not a guarantee of future results.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.