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November 12, 2020 | Paul Chapman
Prior to and during the nerve-wracking and bumpy market of spring 2020, or the depths of 2008, many of us have been conditioned to “just buy the dip”, while others simply freeze and refuse to look at their investment statement at all. Portfolios often remain relatively static in their construction and allocations, as they are assuming that the environment will continue to mimic that of the last decade or more. The unprecedented run in risk assets combined with low volatility prior to last spring had lulled investors into a false sense of security, and most take the “if it ain’t broke, don’t fix it” approach their portfolio construction and overall risk management. We’ve seen the same security blanket set into investor’s minds as markets have rocketed back post-March.
Securities regulators rightfully frown on investment managers making promises about performance. But here are some guarantees that investment managers can make about equity investing – an equity portfolio is virtually guaranteed to:
We have seen a few exceptions to this throughout the recent bull markets. Outside of the bumpy ride so far in 2020, the global financial crisis of 2008, and the tech implosion of the earlier 2000’s, markets have generally been on a tear in the last 40 years or so. A number of tailwinds have driven this: low inflation, low and falling interest rates, demographics and globalization to name a few. These have driven virtually all asset classes to perform exceptionally well. But is this the “normal” that you expect to persist into the next decade? This certainly hasn’t been the “norm” outside of this recent window in history.
Note this figure: over 90% of the total price appreciation of the regular 60/40 equity/bond portfolio over the past 90 years is attributable to 22 years between 1984 and 2007. And almost 75% of the real estate price appreciation in the last century was during this period as well.
To illustrate historical scenarios, we have to be aware of the fact that investors experienced an 86% peak-trough decline in equities in the 1930s which wiped out two decades of performance, and a 25% decline in U.S. Treasury Bonds during the stagflation of the 70’s. Most investors either seem to think they’re bonds will never go down, so either forget the experience of the 70’s, or weren’t around at the time. Howard Marks of Oaktree put it well in saying that “tail-end consequences of risk – like pandemics, and depressions – are what make pages in the history books. They’re all that matter. They’re all you should focus on.” And this is why we focus on process and risk.
Any bear markets we have seen in our lifetimes has been met with a rapid recovery, which have only emboldened most advisors to placate investors by advising they stick with portfolios that may well prove obsolete moving forward, or prove to offer an inadequate risk/reward profile.
Over the last 20 years, a diversified 60/40 equity/bond portfolio generally did its job – when stocks went down, bonds went up to soften the blow, and vice versa (i.e. correlation of stocks and bonds was negative 27%). Now let’s look at a similar period in history that could well parallel what we’re about to encounter – that is 1949-1969. Like we see today, bonds started that period from very low yields (and therefore high prices) – bond returns are a direct function of the yield you start with. Today, 10-year bonds yield ~90bps. Your returns over the next 10 years will be (you guessed it) ~0.9%, or a tenth of the returns of the previous 20 years! In 1949, yields were 2.7% and rose to 7.7% over 20 years – this means that the actual price of bonds tanked, and investors took heavy capital losses. And bonds also didn’t do their job of offsetting stock moves – the correlation of stocks and bonds was positive 8.7% (so stocks and bonds moved together, not a good scenario when prices start to decline). The reality of low interest rates means that investors need to adapt and construct portfolios differently to achieve similar returns to those garnered over the last 10-20 years.
Source: Datastream
No one can know what the future holds exactly. But what I do know is that the period ahead will look different from the relatively tranquil environment we have come from. Eye-popping asset valuations, record corporate, personal and sovereign debt levels, trillions in negative yielding debt, massive civil unrest stemming partially from populism, historically high income disparity across the developed world driving protectionism, and the list goes on. So portfolios need to adjust to these facts, which will almost certainly persist.
Source: YCharts
I’d posture that the general longer-term outlook remains constructive but there are potentially negative scenarios, and the probability of these is far from zero. On one hand, global debt-levels are eye-popping. If we have an issue servicing this debt, we could see widespread defaults and deflationary deleveraging, which would crush the growth-sensitive darlings of today’s stock market, and equities overall. History has shown us this very scenario during the Great Depression and also the dotcom crash as well as the global financial crisis most recently. At the other end of potential scenarios, massive and unprecedented monetary stimulus, complements of global central banks, along with massive pent up personal savings and low velocity of money could finally all unleash and spur inflation, which would crush both bonds and stocks. If you’re old enough to recall the 70’s, you’ve lived this scenario – real incomes got hit, and bonds suffered massive capital losses to boot. These are all realistic scenarios that we have to consider and prepare for. And we haven’t even touched on how one goes about finding yield or income as we move forward at unprecedented low interest rates.
In my role as an Investment Advisor, I believe in managing risk prudently, preparing for all potential markets and scenarios – we cannot take stability for granted. Static portfolios and simplistic ‘buy and hold’ strategies prove very difficult for most to stomach when markets encounter serious losses and/or volatility.
So let us help you and your family create, truly preserve and grow your wealth through ALL market cycles. The future will almost certainly NOT look like the past.
