As economic cycles go, this has been a long one (currently in the 7th year of a bull market for US stocks). As cycles run longer, many investors start feeling the Board of Governors of the Federal Reserve System (the Fed), currently chaired by Janet Yellen, are both omniscient and omnipotent. In reality, the Fed has inadvertently helped create some of the biggest bubbles and trigger some serious market declines.
The 1987 Crash is a perfect example. When Black Monday (-22% decline in the Dow Jones Industrial Average) happened, it was blamed on “programmed trading.” In actuality, a newly minted Alan Greenspan watched short term rates increase close to 1.5% from August to October only to see people panicking for safety on October 19th.
Again, another misstep was in the late nineties when Alan Greenspan himself coined the term “Irrational Exuberance” in 1996. “Easy money” was the name of the game for three more years, even cutting rates further in 1998 after the collapse of the Long Term Capital hedge fund. The Tech Bubble that ensued saw the Nasdaq index fall from a high of 5,048. After 15 years, we finally reached that level again (see chart below, courtesy of Investech).
Lastly, after cutting rates from 6% to 1% from 2001-2003 and holding them too low for too long, we saw a Housing Bubble emerge that the soon-to-be Fed Chairman, Ben Bernanke, failed to recognize in 2005.
“Top White House economic advisor, Ben Bernanke, said he thought strong U.S. house prices reflected a healthy economy and doubted there would be a decline in prices.” -Ben Bernanke
Now with the first rate hike in nine years around the corner, what are the implications for the economy and more importantly, your portfolio?
We have to acknowledge the risks created by having rates so low for so long. First, nothing is cheap anymore. Stocks are fairly valued, cash pays nothing, real estate has moved considerably off its lows, commodities are too risky and bonds are at all time highs. Too fast of a climb in short term rates could tip the “Apple Cart.” Second, with interest rates so unattractive, many income investors have taken on far too much risk in seeking more yield. Some treating dividend stocks as “cash alternatives.”
It is our opinion that bonds, (but not all bonds) have risk, especially when taking a long term view. Similarly, if the goal is to grow or maintain your purchasing power over your retirement, then cash is a guaranteed loser. Consequently, we have repositioned our clients’ portfolios to have stocks, hedging positions to manage risk, and few non-traditional bonds and very little else. We have seen the recent drop in Master Limited Partnerships (specializing in the energy sector) as a nice entry point to produce some additional income for those that need it.
As the chart above (courtesy of Yorkville) shows, the Master Limited Partnership (MLP) index currently yields 5.05% more than 10 year Treasury bonds. While this only happens about 3% of the time (right axis) , historically the years following have been very good for MLPs (left axis). Hopefully, this is not only a good source of income, but a good diversifier to stocks.
Lastly, looking outside of the U.S. could produce additional diversification. We have heard many saying that while the U.S. is strong now, Europe’s economy is where we were in 08-09. In our clients’ portfolios, we have increased the international holdings in both stocks and bonds to better diversify their risk, and hopefully enhance returns.
Typically, rate hikes are good for the economy short term. The burden of successive hikes, especially over a short period, are another story. It seems our economic data while good (3rd quarter earnings are up nicely, ex-energy) lately, is not currently causing many “over’s:” Over Spending, Over Borrowing, Over Confident. Controlling these “overs” is one of the primary reasons to raise short term rates. However, now that the Fed has announced interest rates will go up, it seems it will be a self-fulfilling prophesy whether it’s needed or not.
Hikes should be enjoyable, good for the body and soul and not end wishing you had turned around sooner. Hopefully, this one is no different for our economy.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.