Investors aren’t limited to only investing in the S&P 500 and the Dow Jones Industrial Average. Every week we share the market trends we are following. We are interested in whether the trends in those markets are continuing or if they are experiencing a temporary or complete reversal.
When we identify trends, we are only concerned about the price data and what it says about any given market. We don’t need to know why a trend has formed to invest, but our human nature wants to understand what is driving them. Each week we try to offer some perspective on what we think the most substantial moves are and what critical drivers are behind them. Here we look at what is going in our globally diversified, non-correlated Crystal Bay Ubitrend strategy.
Last week’s continuing trends:
- Chinese Yuan
- Coffee
- Euro-Yen Cross
- Rapeseed
- Japanese Equities
Last week’s reversing trends:
- Lumber
- Orange Juice
- Silver
- Gasoil
- Nasdaq Index
What we are taking note of:
If you are saving for retirement, I bet you have most of your financial assets split between equities and bonds. It may not be the standard 60/40 split. It may be more weighted towards equities for younger savers and more towards bonds for older savers. Still, it is the unquestioned assumption of asset allocation that stocks are good, bonds are good, and they’re better together.
In the long term, stocks have reliably outperformed bonds. So why have bonds in the portfolio? For two reasons. First, bonds provide current income in the form of interest coupons. This income can be reinvested into stocks, providing a powerful form of dollar-cost averaging. When stocks are down, the bond income can buy more stocks and thus lower the average purchase price.
The second reason is that when stocks are down, bond prices tend to go up, creating capital gains and offsetting some of the losses from the stock portion of the portfolio. This worked really well both during the dotcom crash and the global financial crisis of 2008.
The asset management firm GMO pointed out in their most recent quarterly letter (GMO Quarterly Letter_2Q 2020) that neither of these reasons to buy bonds is valid anymore. The relentless drive to zero interest rates killed the case for owning bonds.
First of all, zero interest rates mean zero coupon. Bonds now yield less than what stocks pay in dividends. They do not provide any meaningful current income and cannot be used to dollar-cost average a stock portfolio.
Second, there is a natural limit on how low interest rates can go. We used to think that zero was the minimum, but we have seen in truly pathological cases (I’m looking at you, Japan, and Germany) they can go a little bit below zero. The true natural limit seems to be in the range of negative 0.4% to negative 0.6% per year. When faced with negative interest rates, people get creative in finding alternative forms of savings, whether they be cash, real estate, precious metals, fine wine, or art.
How are we heading into next week?
With interest rates near their natural limit, bond prices cannot rise during a financial crisis and cannot provide capital gains to protect portfolios from stock price losses. We have seen that play out this year when bonds did little to offset the bloodbath in stocks.
What is then the proper portion of bonds in a retirement portfolio? I believe that the correct answer is zero. Bonds provide very little additional income over cash and present a risk of a permanent loss of capital if inflation and interest rates go up at some point in the future. The role that bonds used to play in traditional asset allocation should be given to a combination of cash and alternative assets with low or negative correlations to equities.