The Top Behavioral Change Coming Soon that Will Impact the Markets and Your Investments...
Financial Fridays - Week 37, 2022 - Everyone understands the economic and market risks out there today, but there is another hidden behavioral risk that is set to kick in soon...
Cartoons of the Week:
The Risk Curve
The chart below outlines exactly what the risk is to all of us BEHAVIORALLY over the next 6-12 months.
Sure, we all know about the economic slowdown, the Fed raising rates, inflation along with energy issues. But to add to all of this, there may be a HUGE behavioral change by all of you that may be a major challenge for the markets as we move into 2023.
This is the chart.....
You are probably thinking what in the heck is that???
Let me explain...
First off, I need you to answer a few questions for me as we go along.
Most of you who read this are investors, members of boards and committees, and/or run an organization.
Most of you have investment responsibility either for yourself or for your organization.
This leads me to my first question.
1. What is the purpose of investing your money?
For most of you, this money is invested with the hope of earning a return.
As Ray Dali famously said:
“Every investment is a lump-sum cash payment now for an income stream in the future.”
I saw this tweet that basically says the same thing.
With an estimated 10,000 people each day retiring, more and more will be positioning their investments from accumulation to distribution to pay for their retirement lifestyle.
Organizations and non-profits invest their money to sustain budget shortfalls and put in place a spending policy to accomplish their goals.
We have been taught for over 30 years that you can take out 3%-5% of your capital each year to fund your retirement or your organizational needs and still be able to keep pace with inflation and fees.
This has been much more difficult over the past 20 years, as highlighted below by one of my favorite charts I show clients.
Efficient Frontier
So what does any of this have to do with that funny chart at the beginning?
That funny chart is a line called the efficient frontier, which connects and outlines the risk and returns of two different assets. These two assets are long-term bonds and US stocks.
As you can see below, these assets are put on a chart where their historical return is on the vertical axes (up and down) and their risk is on the horizontal axes (left to right).
The riskier the investment, the further right it goes. The higher the return on the investment, the more vertical it will go.
Now a funny thing happens when you start to combine these two assets.
With a different mix of these assets, you get different returns and risks.
When you combine the risky allocation of stocks with the bond allocation, the overall risk of the portfolio DECREASES while the return INCREASES!!!
This can be seen below with the red line moving left and up.
Why does this happen?
When you combine two or more assets that move in different directions (uncorrelated), you get a reduction in risk.
This is called diversification and is the holy grail of investing, per Ray Dalio.
By combining different assets, you can lower the risk and increase the returns AT THE SAME TIME!!!
And when you add other assets like Real Estate or small companies to the mix, you are again able to lower the risk while increasing the return.
This lady and gentlemen is diversification 101.
By adding different asset classes together, you can increase your returns for the same level of risk or decrease your risk for the same level of returns.
As the old Wall Street saying goes, it’s about the only free thing when it comes to investing.
So here is the second question for you now that you understand the efficient frontier and diversification.
2. What happens to this theory (or model) when rates go to 0%?
Are you as an investor able to get a decent return with the 100% bond portfolio?
Probably not. Most need at least a 3%-5% return to live in retirement or to fund their organization.
A return of 1.50% for an investment grade bond will not cut it let alone a 0.85% US treasury.
This was the reality of the situation at the end of 2021.
If you went to the bank to buy a CD or a money market over the last 5 years you probably walked away with disgust, still holding your cash wondering what to do with it.
By pushing rates to zero, the Federal Reserve has changed your behavior.
By making the risk-free rate 0%, the 100% bond portfolio on the efficient frontier is so low that no one really was investing in it. (Ugly red circle with X below)
If we factored in the duration risk (TALKED ABOUT HERE) of a 30-year bond at under 1%, in theory, the return would be 1% and the potential one-year risk would be above 100% equity portfolio. (Ugly blue arrow below)
As a result of this, your behavior as an investor has been forced to change. You had to buy riskier assets. You had to go out on the risk curve.
And what is out on the risk curve?
Everything under the yellow circle below: US equities, high-yield bonds, real estate, and commodities (add bitcoin here if you want). Basically, all the assets that have gone up so much in price over the last 5-years.
Here is the next question for you.
3. Why have these asset classes done so well over the last 5-years?
You have probably guessed it. If everyone with a dollar to invest is investing in the same thing because the Federal Reserve is buying up all the bonds and pushing rates to 0%, then the price of those items has to go up.
It’s basic economics 101. Supply and demand.
As you can see below, if quantity stays the same, the price has to increase. You have to go from point P1 to point P2.
This is why Apple, Microsoft, Tesla, Bitcoin, and your house have all gone up so much in value. A ton of money in the system is forced out on the risk curve with a limited supply of items you can buy on that risk curve.
So the next question for you is this.
4. What happens when this reverses?
We have just seen rates move up the fastest on record and we are not close to being done.
Here is a graph of world rates as of June 2020.
And here is the same graph today.
Below is the snapshot of the 2-year US government treasury bond which is now yielding 3.823%!!!
Which at this moment is the highest yielding bond on the entire curve (inverted yield curve across the board - Current Yields are in the blue)
We have seen mortgage rates move above 6%.
Pushing housing demand much lower.
And with the recent higher than forecasted inflation reading, the Fed seems to. be just getting started.
As we said last week (HERE), the Fed will not stop raising rates until the real rate (blue shade below) is in positive territory.
This means the fed funds rate needs to be higher than inflation.
Ray Dali feels to get there we need to see the fed funds rate at 4.5% to 6%!!!
Deutsche Bank says rates need to get to 4.5% by December and 5% + in 2023.
This means those bonds on that efficient frontier chart at the beginning will be going from 1.50% at the end of 2021 to something close to 6% - 7% by the middle of 2023!!!!
Now here is the final question for you.
5. What will you do when you can get 3% on your checking account, 5% in a bank CD, and/or 7% investing in a normal bond or government treasury?
You guessed it. At least I hope you guessed it.
All of you will be selling your “risk” assets and going to buy higher-yielding CD’s, bonds, and risk control assets.
Cash will no longer be trash.
Those who have invested in real estate for a great return over the past 10 years may just sell their investments and buy a risk-free treasury now.
And when everyone tries to exit the same door of crowded investments simultaneously, things may get ugly.
So let’s hope this does not happen. Let’s hope inflation comes in fast and the Fed will stop soon on their plans to raise rates.
But please understand the underlying behavioral changes that are just starting. Know there will be some dislocations if what took 20-plus years to get to can be reversed in under 2 years.
the good news is when we get to the end of this, we may be in a better position to again price assets accordingly and to earn yield and returns on our cash or new cash holdings.
Have a wonderful Weekend!!!!!