Goldilocks, RevisitedSubmitted by Affiance Financial on September 13th, 2013
By Seth Meisler, CFA CPA/PFS
NOTE: This article was originally authored in late August, 2013.
We construct narratives (tell stories) to explain what we don’t understand. But stories aren’t facts, and sometimes they’re wrong.
Recently my family vacationed at my in-law’s cabin, staying with my sister-in-law’s family and the five children between us. One evening we put the children to bed as usual and retired to the porch, where we played games and chatted. When my wife and I turned in later that evening, we found our oldest niece sound asleep in our bed. Rather than disturb her, we went and slept in her double bed. Hey, we’re parents. We’re flexible.
When we found our niece in our bed, we concluded that her cousins (i.e., our children), well known for being excessively talkative, had kept her awake until in desperation she went and found the closest quiet alternative. But the next morning, more like the bears than Goldilocks, she said to us, “What was I doing sleeping in your bed?” It turned out that, contrary to our assumptions, she had actually been sleepwalking and landed in our bed. Despite our explanation of chatty children disturbing her sleep being logical, reasonable, and based on the historical facts available to us, it was completely wrong.
What’s the moral of this story? When people are presented with an unanticipated and not immediately explicable event, they try to make sense of it by constructing a story. And, based on past experience, we fill in facts that seem reasonable to create a narrative based on those facts. If it all sounds good, then as my high school English teacher used to say: “If it isn’t true, it should be.”
We see the same situation occurring in the investment world, which is particularly vulnerable to ill-drawn conclusions because the economics are truly complicated and poorly understood, even by experts. After all, if it were clear how to fix the economy, wouldn’t it have happened by now?
Another problem is that “the market,” however one defines it, is an unusual entity, neither man nor beast. Despite the fact that it deals in a quantitative factor—dollars—it operates based on a qualitative factor—the emotions of human decision-making. Couple this with our desire to make sense of events and fill in the blanks, and we arrive at our narrative de jour: the bond market.
For the past four years, since 2009, we have heard the familiar refrain that inflation is coming. Chicken Little? I’m sure at some point there will be inflation, but this narrative holds that inflation is just around the corner—a wolf at the door, if you will (heads up, Red Riding Hood?).
Rising interest rates?
The second narrative over the past four years, and a close cousin of the first, has been the concern of rising interest rates. This particular narrative has lately been associated with the Federal Reserve “tapering” their current $85 billion per month of bond purchases (referred to as “quantitative easing”), thus raising the specific concern of investing in bond funds.
These fears played-out in June, when interest rates did indeed rise by close to 1%, a tremendous relative increase in a very short period of time. What has been so interesting is that investors themselves effectively drove up interest rates based upon the perception, not the fact that the Fed planned on tapering. Equities were also shaken by this announcement and, during that same period, suffered greater losses than bonds. However, they reversed course once the Fed changed its tune. Some journalists have called the June event a “Taper Tantrum.” To me, it appears that the change in interest rates and investor behavior was based on a narrative constructed by investors, not by actual events.
The Affiance Financial approach
At Affiance Financial, we look at these narratives and subject them to careful scrutiny, then go on to make our own assessments of the economy and markets. While investors today appear certain that the days of low interest rates are over, I’m not sure the narrative is quite so clear cut. While I am clearly in the minority, I question the story being told. What follows is an explanation of our assessment process related to the current bond narrative.
Below is a graph in which the blue line is 10-year Treasury yields and the red line is the change in the consumer price index (essentially a proxy for inflation). Notice how treasury yields tend to be highly correlated with changes in the CPI. It does not appear as if CPI is meaningfully increasing; therefore I would expect interest rates to remain low for the time being.
Chart courtesy of the Federal Reserve Bank of St Louis: http://research.stlouisfed.org/fred2/.
In addition, we’ve been seeing an unusual phenomenon. During periods of quantitative easing, long-term interest rates have been going up. It is important to note that while the Fed can control the short end of the yield curve, they have no control over the long term. When quantitative easing has decreased, long-term interest rates have gone down. Therefore, I’m not quite sure the prevailing opinion—that interest rates will go up when Fed tapering stops—is correct.
Chart courtesy of The Chart Store: https://www.thechartstore.com.
The last question is growth of the economy. The economy has been growing, but certainly not at the pace prior to The Great Recession. If we’re not seeing robust economic activity, why would we expect interest rates to increase? The only case for inflation I can see would be due to resource constraints. That is, a lack of supply could create a situation in which smaller increments in demand could create larger price increases. However, I believe we’re likely years away from this scenario.
The historical record is also consistent with my opinion. After the debt crises of both 1873 and 1929, long-term government bond yields were at 2% and remained at those levels 13 to 14 years after the initial event.
The bottom line is, unfortunately, the data I’m seeing doesn’t fit so neatly into the prevailing narrative of rising bond yields. As such, while I am admittedly in the minority, I believe today’s concern about investing in bonds is excessive. This doesn’t mean we won’t have fluctuations in yields which temporarily hurt price value. But I believe these price fluctuations are transitory and do not bolster the case for climbing interest rates. Yes, someday interest rates will go up—but that’s like the weather forecaster who predicts rain every day. The prediction will eventually come true, but provides absolutely no value in determining whether you need to take an umbrella to work.
So, what if I’m wrong and interest rates do go up? For savers, while initially painful, increased interest rates would be a great benefit over the long term due to higher interest received on reinvested assets.
Bonds in more detail
Bonds in general have two ways of generating a return on investment—interest income and price appreciation. The interest income effectively acts as a stabilizing item, protecting investors from negative price movements. How does that work in practice?
Even though bond prices initially go down after a rise in interest rates, over time the interest received on the bonds offsets the drop in price. In addition, the interest received can be invested at a higher interest rate, thus benefiting savers.
It is also important to note that over time, the larger portion of bond returns is generated by interest income as opposed to a change in the value of the price of the bond.
Bonds expected to remain stable
I do not expect the bond market to experience a prolonged period of low returns. The consistent yield provided by bonds helps keep returns stable, and unlike stocks, this predictable recurring income gradually brings returns back into the positive. I don’t believe the case for bonds is dead. A bond allocation provides the consistent income and portfolio stability investors expect. As such, I would “taper” my concern over bond prices.
Our specific investment strategies have been as follows:
Over the last 12 months, we’ve tilted more toward equities, where in many cases the dividend yield is greater than the bond yield—particularly for investors with longer time horizons that can handle the increased volatility.
We’ve been hedging our analysis by increased exposure to convertible bonds that provide an additional hedge if interest rates rise.
In short, we’ve ignored the noise and the pundits. And we’ve ignored the emotional story and not allowed the prevailing narrative to dictate strategy.
Investment Adviser Representatives offering securities and advisory services through Cetera Advisor Networks LLC. Full-service Broker Dealer, member FINRA, SIPC. Cetera Advisor Networks LLC and Affiance Financial are not affiliated. Advisory services also offered through Affiance Financial.
The views represented in this communication are those of Seth Meisler and are not intended to be construed as a recommendation to buy or sell any specific sector or holding. To discuss holdings in more detail, please contact your financial planner.