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To help prevent the next Great Depression, in 2008, the Federal Reserve increased the “price” of avoiding risk.
Fearful investors seek the safety of Treasury bonds (as well as government agency bonds and FDIC-insured CDs). When they do so, they forgo the risk premiums available from non-Treasury debt and equity investments. Driving the rates on Treasury bills to virtually zero led many investors who rely on a “cash flow approach” to investing to frantically search for higher yields.
Higher bond yields can be achieved in two ways. The first is to take incremental maturity risk, which would increase the volatility of the portfolio and subject you to increased risk of unexpected inflation. The second is to take incremental credit risk.
As the director of research for The BAM Alliance, whenever markets head south for an extended period, the number of calls I get from clients and other advisors jumps. This time is no different.
With that in mind, I thought it important to share how investors should be thinking about the recent drop. To begin, there is always a reason for investors to worry about the stock market, be it valuations at historically high levels, the economy, 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.” It’s also why it’s often said that “bull markets climb a wall of worry.”
While the news on the economic front has been just about as good as it gets, there are always things to worry about. To make sure you have a balanced view of things and are not just obsessing about potential risks, let’s first look at some of the economic news:
It’s important that investors understand all risky assets can experience long periods of underperformance.
My favorite example that makes this point is that, for the 40-year period from 1969 through 2008, the S&P 500 Index returned 9%, and so did 20-year Treasury bonds. Making matters worse, while producing the same returns as long-term Treasuries, the S&P 500 experienced far greater volatility—its annual standard deviation during the period was 15.4% compared to just 10.6% for Treasuries.
That equities could underperform Treasuries for 40 years surprised many people, but it shouldn’t have. No matter how long the horizon, there must be at least some risk stocks will underperform safer investments.
Another risk premium also failed to appear over this same 40-year period, one that has received far less, if any, > SEE MORE
While I could provide an almost endless list of forecasts that went wrong from so-called experts, among the most infamous was surely Meredith Whitney’s December 2010 forecast of between 50 and 100 “significant” municipal bond defaults, totaling “hundreds of billions of dollars.” In March 2011, noted economist Noriel Roubini jumped on Ms. Whitney’s bandwagon, predicting $100 billion in defaults over the next five years. Such forecasts led to massive withdrawals from municipal bond mutual funds.
The massive scale of problems that Whitney and Roubini anticipated didn’t occur because many (though far from all) governments took actions to address the problem, cutting spending and raising revenues.
However, investing in municipal bonds is riskier than many investors may perceive, with last year’s $74 billion default by Puerto Rico providing a reminder. There have been other significant ones in recent years, including > SEE MORE
I think most investment professionals are generally aware of how well the S&P 500 has done relative to virtually every other asset class since the end of the global financial crisis (GFC). A bit more precisely, the S&P 500 is up 352 percent from March 2009 through October 2018 while international developed stocks, emerging markets stocks and bonds are up 140, 142 and 39 percent, respectively. What you might be surprised to know though (I certainly was) is that it’s almost impossible to simulate another same-length period where the S&P 500 had better risk-adjusted returns. In other words, saying the S&P 500 has done well during this period is a gargantuan understatement. As we will see, it’s done so well that it’s reasonable to ask whether anyone alive will ever > SEE MORE