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The 100-Year Bull Market
What does it mean to be "diversified" when everything is expensive?
That's a good question. Does "diversification" help when everything is in a bubble? Maybe at the margin, right? I mean, "diversification" entails holding assets the returns on which are negatively correlated but when all of those assets are in bubble territory, the implication is that at best, returns going forward are going to constrained and at worst, returns will be negative. So while being diversified across a bunch of asse
The impact of a bear market in bonds on equities will depend on the expectation for its duration – which will be a function of inflation expectations. Missing from the charts pasted in the article is the analysis of how real interest rates move and the effect on equities – which is surprising since real return spreads are the only thing investors concerned with.
It’s more useful to note that the real five year treasury yield in the current century has ranged from a peak of 240 bps in June 2007 to a bottom of negative 160 bps in April 2012. For the past several years, the real rate has hovered just above and below zero. A cyclical move up to 49 bps in late 2015 was enough to trigger (or precede) a temporary sell-off in equities until that real rate declined – and declined sharply to about negative 40 bps. The current real rate is 37 bps and rising and equities seem to be taking it in better stride than they were ahead of that 2015 cycle.
My guess is that bond markets have been influenced by somewhat unnatural stimulus (Gee, who’d a thunk?) and if/as that unnatural stimulus is removed then bond markets will react. The expected direction would be to revert up historical averages on real rates in the neighborhood of 100 to 150 bps. If equities have to toe the line, that means equity earnings yields would have to rise by maybe 100+ bps from their current level of around 4%. Round numbers, that means earnings will have to accelerate (which they have been) and/or prices will have to adjust. Absent more earnings acceleration, that means – round numbers, the fair value of the SPX is maybe 20 to 25% lower than it’s current level – which shouldn’t be a big surprise to anyone.
This, of course, could all be accentuated by the leverage situation we are now in being significantly greater than in the past – as to carry trades as well as corporate debt – so that 20-25% equity correction could become something more significant unless we start de-levering. Absent some de-levering, I guess another 40% drawdown is not out of the question – and that might surprise people who decide not to sell at the first “bottom.”
Since the equity re-set in that scenario will have been triggered by a rather sharp bond market price decline, that will mean the 60/40 approach won’t do anyone any good – which is the point of the article. This, I believe, will be the most palatable outcome. There are other much more painful scenarios but I do believe this is the most likely scenario in the foreseeable future.
I don’t think this is rocket science or anything, but it does beg the question of who would be allocating 40% into longer term nominal debt at this point. TIPS, on the other hand, were a decent deal at the end of 2015, a bad deal for much of 2016 and 2017, but they are looking better and better lately.
Seems to me, from a policy standpoint, a heavy hand may be better than this dribble approach. Find the “equilibrium” real rate, whatever that is now, and go from there. In order to do that we need to push real rates up to the point where we get a reaction. We know where that point was as of late 2015 and it looks like it’s going to be a bit higher now based on where we are. Someone chickened out in 2016 and didn’t let that correction run its course without cramming down real rates to below zero again. Since then, real rates have been clawing their way back up and we should soon be seeing if, when and how we get a reaction.
Here is my ‘diversification’:
1) Spending less
2) Selling on FleaBay and Craig’s ALL the crap that is clogging space (sidebar) if I acquire something, I get rid of something
3) Staying debt free
4) Teaching two young men how to build aluminum boats
5) Raising composting worms
6) Fixing with my own hands all the shit that is in need of it
7) Investing in time spent with friends
As tawdry as this all is, it remains rather satisfying with no downside….
Attach that to the Goldman 2018 outlook.
WW-
you can refer to all the ‘policy errors’ or ‘inflation spikes’ or ‘growth’ as to discern a ’cause’ for a weak 60/40 outcome. in a situation where stocks are valued above 99% of all time; and rates are the lowest ever recorded….simply accepting that the likelihood of bond prices going down along with stock prices, in which all investors will feel like a 100% equity investor while having been told they will only do 30% of the downside, is a good starting point. but the only soolution is raise lots of cash, which is NOT what the brokers do today. ride it out and in 20 years from now you too will see 4% annualized from today, just mind the 75% gap during the first 10 years of that 20.
People forget that you can be long cash. Get it? They sure don’t.