All of us have had run-ins with a grumpy old man. He may be the guy you never want to run into at lunch, because to him the whole world is screwed up. He tells you the economy is terrible, the government is bankrupt, no one can find a job, everyone is in debt, and the future for our kids and grandkids is dismal. I will admit that I try hard not to assume my role as a grump, though at times I do find myself slipping. When I do, both Justin and Libby are quick to remind me of my deficiency.
Yes, all of us old time investment managers making a case for conservative investing may just be grumpy, but today, I am going to assume that we are not. I will assume that we have learned from decades of experience managing portfolios for others. All of these “old men” have lived through an exceptional period of time for long-term conservative investors. According to Goldman Sachs, a traditional 60/40 portfolio, (60% invested in the S&P 500 index stocks and 40% invested in 10-year US Treasuries) generated a 7.1% inflation-adjusted return since 1985, compared with 4.8% over the last century.
Maybe these exceptional returns have turned us into grumps wishing for the old days when it was easier to manage portfolios. Easier because there was always a choice to balance a portfolio based on price. When common stocks were expensive relative to risk free treasury yields, you just sold a little stock and increased the bond holdings at a rate exceeding the rate of inflation. Then you would wait until common stocks became cheap again. Of course they always did, sometimes with a bang, other times with a whimper, but you knew you could just wait it out. Today that option is limited, as current interest rates do not cover inflation, let alone taxes and fees.
Those of us who make our living as analysts or portfolio managers understand the quantitative use of the risk free interest rate in the valuation of common stocks. The few of us managers who have been around since the early eighties have a first-hand knowledge of the extreme influence short term rates have on investor opinion. I bring up the early eighties because it was the last time both common stocks and bonds were extremely cheap, yet individual investors failed to take advantage of this extreme.
Shortly before Paul Volcker, the Chairman of the Federal Reserve at the time, was determined to break the back of inflation, the mutual fund industry created the money market fund. This provided a low risk interest bearing investment with check writing privileges that paid interest earned in the “money market.” These funds paid, as they do today, a floating rate that increased or decreased relative to short term rates that were for the most part controlled by the Federal Reserve. When Mr. Volcker increased rates to the extreme, money market funds were paying in excess of 20%.
During this time, the Dow Jones Industrial Average was below 800, with an earnings yield above 14%. The thirty year Treasury bond reached 15%, and 10 year FDIC insured CDs were yielding 17%. You’d think it would have been easy for everyone to take advantage of this great opportunity, but that wasn’t the case. Most individuals just wanted to open a money market mutual fund.
Today, we are now at another extreme, only this time it seems everything is expensive. The Dow Jones Industrial Average is above 24,000, the S&P 500’s earnings yield, based on 2017 consensus earnings of $132.75, is 5.01%, and the 10 year US Treasury Bond is yielding 2.32%. This is why us grumpy old men are cautious. Not because we feel the economy is terrible, debt is unmanageable, or the future is doomed, but because on average, everything is more expensive than it has been for decades.
I want to clarify this difference in expected returns from the early eighties to today based on the S&P 500 index and the 10 Year Treasury Bond.
Expected Returns from a 60/40 portfolio in 1982:
Will the markets decline, and will interest rates stay the same or increase? I wish I could give you the answer, but I cannot. Knowing that market prices are higher than historical averages, and interest rates are lower than historical averages, does help guide us in the construction and maintenance of portfolios. It helps us recognize that easy money from owning common stocks and bonds is probably over. That great opportunities are few and far between, and that a cautious approach for a conservative investor is warranted.
Of course we could be wrong, and caution could result in a less than average rate of return. We must be willing to accept that. We also know that opportunities will make themselves available independent of averages. We don’t know when, or for that matter what, these will be, but we will be prepared to take advantage of them when they arise with the reserves we have been building in portfolios.
Until next time,
Kendall J. Anderson, CFA