Interest rates are rising, not because the Federal Reserve isn’t trying to do everything in its power to keep them low and finance an explosion in federal debt, but because the “bond vigilantes” are revolting based on a rising inflation rate and a massive 25% increase in total federal debt in the last 12 months alone, with an additional $3 trillion in spending proposed.

Of course, as interest rates rise, bond prices fall. Many bond funds, usually leaned on for low risk compared to stocks, have seen 6%-7% drops so far this 1Q 2021. This year may end up being the first double-digit negative return for bonds in a very long time. But, given the course of things in Washington, more could surely follow. That will shock a lot of 401(k) participants who are relying on bonds to keep their money intact for retirement. Those in short-term target date funds are also vulnerable, since bonds make up a very significant portion of those funds.

So, what is your plan’s safe haven? Do you have a guaranteed fund with a stable price? Do you have any alternative funds that would provide income with continued low volatility like say a long-short fund, a market-neutral fund, some of which have positive returns of several percent in this down bond year?

If you don’t, you might want to revisit the fixed income portion of your investment lineup, the portion that is usually the least examined and weakest part of most 401(k) plans I review.

You should also educate your work force on the risk in bonds, something of which they may be unaware. Then highlight some alternatives if you have them. If you don’t, you’d better get busy.

Which raises another point – has your current investment advisor talked to you about this? If not, give me a call.

Growth is Accelerating

The federal government is attempting to stimulate growth as much as it can by massive spending, pushing debt to a level relative to the size of the economy that surpasses even WWII. I think you know how I feel about that. This is not WWIII, not even remotely close.
The Federal Reserve is also, and the bond market traders are becoming concerned about this, keeping record low interest rates in spite of rising inflation, especially in housing prices.

As more people get vaccinated and the economy continues to reopen, consumer spending will continue to increase, probably by quite a bit. I suspect we will get more growth than the DC crowd bargained for and inflation ought to be a very real worry.

King Kong vs. Godzilla

The Fed has it badly wrong here and I have a lot of good company in that opinion. I think low rates have more to do with keeping interest paid on the exploding debt from becoming a huge budget item than they do stimulating a weak economy. But, that risk of mounting interest payments ought to make the Fed, Congress and the White House stop and think about whether exploding the debt is a good idea. If they did, the thought passed quickly.
Already concerned bond market pros are selling more bonds than the Fed is buying, counteracting the Fed and pushing Treasury and mortgage rates higher. That takes an enormous amount of selling because the Fed is in the bond markets as a King Kong-size buyer, buying bonds and mortgages in staggering amounts in order to try to keep their prices up and thus their effective interest rates low. Remember that when you pay more than face value for a bond with a fixed interest rate you lower your overall return because the principal you lose when you get face value back at maturity offsets some of the interest earned. So, higher bond prices = lower effective interest rates.

This seems to me to be a King Kong vs. Godzilla showdown between a government set on stimulus at any cost and people in the bond market with concern for the value of their holdings as inflation begins to eat away at them reacting fearfully and selling bonds in a big way. You may have seen mortgage rates move up ¼% in the last week or so and I think that has a lot more to go. That means higher costs for home-buyers but it also means principal losses for bond owners. Thus, I am steering clear of this bad movie. See below.

Bond Strategy Change

Bonds have not been my favorite investment over the past two or three years and we don’t have a lot there, preferring the income and growth of alternative investments. But what we do have there, needs to be shifted into those bond funds less susceptible to losses as rates rise. That generally means floating rate or high yield bonds and I am replacing our few existing funds along those lines.

Stock Strategy – Out with the Old, In with the New
Stocks are changing too. Over the last few years, large growth stocks have completely dominated. Kind of like 1999, if you weren’t in them, you weren’t making much money most likely. We were and we did.

Over the last 12 months, for those more aggressive accounts that do individual stocks, we were pretty well-positioned with an emphasis on stocks that were beaten down, and with one exception that few people held, we did extremely well.

Recently, say the last six months, the big tech stocks that have been the darlings of Wall St. and Main St. for several years have flattened out or declined. In their place, small stocks and yes, value stocks have taken their place. We need to shift with this, in fact, we are probably overdue, and you will see a change there too. Large growth has gotten to where almost everyone had some and when that happens, sellers at some point begin to outnumber new fans and things move elsewhere.

With the recovering economy and value stocks having been out of favor for years, many stocks are underpriced. Small stocks have had a terrific start to 2021 but they probably have additional catching up to do. So, you will see most of your big growth funds replaced with value funds, focusing more on midcap and small stocks.

Just FYI, this tilting the portfolio toward the trend, not frequently, but as major changes occur has significantly helped performance. I don’t change often because I have learned through studying my past performance that less frequent changes are associated with higher returns. But, changes at major turning points are important. I have been doing this since 1998 and it has proven to work much better than the old broadly diversified, a fund in every style box approach that I used to use and which is still used by many other investment advisors.

Tax Consequences

Fortunately, 95% of the accounts I manage are in tax-deferred vehicles like IRAs and 401(k)s so in those accounts there is no tax. In the few taxable accounts, I think it is well worth paying the capital gains tax which for now is 15% of gains for most clients, plus state tax. Unless a position is a very long-term one, I try not to let taxes dictate investment decisions.

For those clients with taxable accounts, I will be calling to talk about this move. For nontaxable accounts with discretion, I plan to put this into action over the remainder of the week.
Let me know if you have any questions or concerns.

OK, plan fiduciaries, now that U.S. Treasury yields average 1% on the 10-year note, what are you going to provide for employees in the way of low risk investment options?

More to the point, what are your older participants supposed to do to protect their retirement savings and continue to grow their retirement nest egg?

Having most of the money in bonds may mean an upside of little more than 1% interest and when rates go up again, most bond prices will go down, initially offset by only  1% interest. Bonds may now offer more risk than reward.

In a 2020 target date fund, the bond portion may provide more risk than your participants expect, leaving them with risk assets (stocks) and more risk assets (bonds with falling prices).

It might be time to talk about your investment options.

You might want to talk to Dave Hoshour for ideas.

What are the most important things in a 401(k) retirement plan?

What companies say – 

1. Employees understand and like the plan
2. Good employee participation
3. Good investment choices
4. Reasonable costs
5. Good vendor service and communication

What regulators say – 

1. Plan is run in the sole best interest of participants
2. No self-dealing on the part of plan fiduciaries
3. Prudent, documented oversight by fiduciaries
4. Reasonable costs that are benchmarked on a regular basis
5. Money is properly allocated in a timely manner

What employees say – 

1. Easy to understand
2. Good company match
3. Good investment choices
4. Help with understanding what investments to choose
5. Help with knowing how much to contribute

How is your plan doing on these metrics?

THE ECONOMY

The economy continues to rebound, but the rebound is far from evenly distributed and has been thrown more in doubt by the huge surge in COVID 19 cases the last month and less in doubt by the news that the trials of Moderna’s vaccine produced very strong results in testing and appears to be quite effective at getting the body to produce antibodies against the COVID 19 virus.

Industrial production

Industrial production has had the roughest time rebounding as witness the following chart.

Believe it or not, industrial production did not dip as low as 2009 and the pace of recovery is much faster, but it is very unlikely to continue at the present pace for very long and I expect that super-skinny V to widen out a good bit. If you are fortunate it will take less than the six years it took last time, but it would surprise me if took less than thee years and if the last bit of recovery doesn’t prove to be stubborn.

Consumer Spending

Consumer spending, which is as you have probably heard 100 times, is 2/3 of the economy, is rebounding very nicely. It may not surprise you to learn that online purchases are actually higher than at the start of 2020. In-store purchases, represented by the code “card present” in the second chart below, are more than halfway back already, though tailing off a bit with the resurgence in COVID cases.

Employment

Jobs are necessary for spending and production to increase for more than a blip. There the news is not as positive in terms of recovery. Jobless claims are definitely going in the right direction but are not even close to halfway recovered like we are seeing with spending.

If that seems odd, recall that 60% of those laid off are receiving more in stimulus checks than they were getting in wages. It appears that Rep. Pelosi is firmly committed to continuing that in a new aid package being considered and while the White House is apparently opposed, my guess is that Congress will prevail again. It should not surprise anyone if while providing welcome relief to those who do not have jobs to go back to, it is a drag on the pace of people returning to work. I’ll let you debate the merits of that over the dinner table.

Consumer Real Estate

On the other hand, there is trouble in residential income real estate. This chart of the confidence renters have in terms of making their rent payments is pretty alarming. I’m not sure whether to be more concerned for the renters, the landlords or the holders of residential mortgage paper. Remember that is not necessarily banks, because banks typically make the loan, take the fees, and sell their mortgages in packages. If your bank still holds your mortgage, that is fairly unusual these days.

Bankruptcies

This is the other shoe in terms of the economic impact of COVID policies. I don’t have a chart on personal bankruptcies, but I do for corporate bankruptcies and it is not pretty, basically on par

with 2009. Bankruptcies should be to some extent a trailing indicator and I think you should expect this number to continue upward, surpassing the number seen in the 2008-2009 recession. It just takes time for businesses to throw in the towel and it we keep getting reports of retailers closing down all their stores, whether it is Pier 21, Penny’s or Macy’s. The decline of the shopping mall, especially those that are not upper end in terms of tenants will accelerate as a tremendous amount of anchor tenant space become vacant hulks.

Outlook for the Economy

The outlook for continued recovery depends greatly on the control of COVID 19. That depends a lot on quarantining, wearing masks, avoiding contact with those most at risk, whether or not school’s resume in-person instruction and how many people are vaccinated when the vaccine becomes available.

Here is the percentage of people wearing masks in public from June 29 to July 5. It has likely ticked up some and with more corporations requiring it, will likely increase some more. At this point, it does seem that the Administration is open to a national requirement.

Now, if no more than half the population is wearing masks now, what do you suppose the vaccination rate will be? It will depend a lot on who is president in January, how many corporations require vaccines for their employees and how many parents vaccinate their children. My guess is that in the first six months, no more than 60% will be vaccinated and it will not surprise me if that proves to be optimistic. Eventually, it may be closer to 75% but I have my doubts about that. That likely means that COVID is a factor longer than many people are hoping for and to the extent that is true, the recovery will take longer as well.

INVESTMENTS

As I mentioned last time, my clients have generally done well in the face of the biggest economic blow since the Great Recession. Most are somewhere between -5% and +5% for the year to date, with the higher end generally represented by my more aggressive clients for which we bought more individual stocks when they were low in late March and early April.

 Bonds

Our bond funds have disappointed me, with most slightly under water for the year to date because they have been light on government securities which is the portion of the bond market to show the best returns by far. But, with U.S. Treasury rates at the rate of inflation or below, who can blame them? I certainly don’t want to chase government bonds now so we will stick with our funds that have very good long term records, though of course past results are not guarantees of future returns.

Income Alternatives

The past few months show why I think it is important to diversify, especially when it comes to income investments. Blackstone is our largest real estate holding and it is down only slightly on the year and its worst month was not bad at all, especially compared to high yield bonds or stocks.

Accredited investors, those with at least $1 million in liquid net worth and with sufficiently large accounts with me to be able to reasonably invest in Strategic Wireless Infrastructure Fund did not see a drop at all. That continues to be one of the investments I am most pleased with.

Those in the Blackstone GSO Secured Lending Fund have seen a slight drop in price but all of the loans in the portfolio are current in their payments so the drop is strictly tied to market pricing. Since the loans are expected to be held to maturity and to generally be paid off within three years, I am not at all worried about short term pricing swings.

Stocks

Here is a year-to-date map of the stocks in the S&P 500 index. The size of the blocks represents the relative sizes and weights of the companies in the index. Gee, anything jump out at you?

Yes, Amazon, Apple, Microsoft, Google and Facebook dominate the index, both in terms of size and performance. If you look closely, you can see the larger sections for the industries like tech and health care and you can see that the best places to be this year have been tech, health care and retailers with a large online presence or involved in home and garden.

Style Sectors

Here’s another way to look at it. Again, the conclusion should be obvious as to which parts of the U.S. stock market are doing best. I have used the Morningstar Style Box format and filled it in and colored it with returns from several Russell indexes to illustrate returns. These are YTD returns through July 15, 2020. Data is from Morningstar.

Since the five big growth stocks dominate the large cap growth category and spill slightly into the midcap growth box, you can see how this correlates with the map of the market I showed above.

STRATEGY

 My investment strategy obviously varies by client. For conservative investors, it is a time not to panic. The worst thing to do earlier this year when stocks and bonds were down was to sell out. I still believe that it is generally better to ride out most market swings and that when things are dropping quickly is nearly always the wrong time to be selling. Diversification is usually your friend and timing is usually your enemy.

For moderate and growth-oriented investors, there are still discounts on good companies but the easy money has been made. Some of the hottest stocks in the recovery have seen some profit-taking lately. Market leaders are still leading but their valuations are getting pretty pricey. Whether they will get even more pricey is hard to say.

The gap between pricing on what many people call value stocks and the fastest growing companies is at historic levels. That will of course correct but the timing is extremely difficult to get right. Market trends can go far past what a level-headed investor might consider reasonable.

For my part, I like to stick with what’s working until the trend turns, so I generally continue to emphasize large and midcap growth stocks with some weighting in large cap core as represented by the S&P 500 Index, though that is obviously being dragged over toward the large cap growth category by the outperformance of the most heavily weighted stocks in the index being large growth stocks.

As always, let me know if you have any questions, concerns or if your financial or life circumstances have changed significantly.

Thanks to Liz Ann Sonders, Chief Market Strategist at Charles Schwab, for her amazing twitter feed which is the source for every chart here other than the map of the market and the style box chart. Also note that mention of any specific investment does not constitute a solicitation to buy it.

Dave Hoshour

I am the lone conservative in my family. I also subscribe to the NY Times, a high quality paper that I find aggressively and pervasively anti-Conservative. While I find that very annoying, I read it anyway because I want to be informed.

If you are a liberal, I encourage you to do the same from the other side. If you’re not, you should also listen up.

Back into the Black, Temporarily?

As of the start of this week, many of my clients were in the black for 2020 and nearly all the rest were down some single digit percentage for the year. That is due to good fund selection by focusing on funds favoring large growth companies, good timing on buying some beaten-down high-quality stocks and good stock selection on those purchases. It is also helped by diversification into non-stock market investments that did not go down nearly as much as did stocks, though they have not recovered as quickly either.

But, just as the S&P 500 index, a major barometer of large stocks, got back to breakeven for the year, we are starting to see some profit-taking. This should not surprise anyone. What is surprising is how fast that index erased a major downturn (known as a bear market). It took less than 60 days, by far the fastest stock market recovery from a bear market ever. Of course, the downturn was remarkably fast too.

Why has the Market Been so Strong?

So what has made the stock market go up so much since late March? It seems ironic that it should happen as unemployment numbers that were around 4% in February, soared to 14%, and by the Labor Department’s admission, if they had been correctly reported, would have shown 17% unemployment. Those are numbers you and I probably never thought we would see in our lifetime, numbers far worse than even 2008-2009, numbers that seem straight out of the Great Depression of the 1930s with its long soup lines, widespread bankruptcies and countless other woes.

The answer from many people is that the stock market is a forecaster, looking ahead at least 6-12 months and that it reacts to what investors believe will happen that far out. That may be part of the answer, but another major component is that the Federal Reserve has again flooded the world with newly created money, money it creates by buying bonds with its blank checkbook. That money goes to banks in a process that is mysterious to most investors, but it is the major reason, in my opinion, that the stock market went up so much after 2008 and has done so again in 2020.

That money is designed to be loaned by banks and spent by corporations and individuals to bolster the economy. But, when economic uncertainty is high and corporate chieftains are unwilling to spend, and when stocks are rising at the same time, much of that money finds it way into buying stocks and other investments. I am certainly not complaining, nor are clients.

Who’s Afraid of Debt?

At the same time, the U.S. Treasury is borrowing an additional $3 trillion dollars this year to pay for the stimulus packages passed so far, with talk of another package on the way. For perspective, the IRS collected $3.5 trillion in taxes last year while the federal government spent $4.4 trillion. Of course, tax revenues will be lower this year due to lower personal income and corporate profits, so that gap will widen a lot; then add to it however many trillions we eventually spend on stimulus with no revenue to pay for it. So, in one year, after essentially mandating a huge recession, the government in an attempt to soften the blow is going to spend somewhere between $7.5 and $10 trillion and probably collect less than $3 trillion.

Who Buys All This Debt?

Who buys all this debt? Most people think China, but that is far from correct. China is the U.S.’s largest creditor, but it only holds 5% of U.S. debt, according to Investopedia.

I’ve written this before, but the largest holder and buyer of U.S. debt by far is…wait for it…the U.S. government. Specifically, it is the Federal Reserve, once again bringing out that blank checkbook. As of May, the Fed owned nearly $7 trillion in U.S. government securities and it is buying more as fast as it can.

How long can this go on? As long as the Fed wants and the U.S. can afford to pay the interest on the debt. Don’t ever doubt that keeping that interest rate extremely low is a major reason why the Fed has promised to keep interest rates low. And even if the interest needing to be paid every year is skyrocketing, for the time being, other countries are doing the same thing and nobody seems concerned yet that spending far exceeds income. Don’t try this at home.

What’s Ahead?

States are unwinding their restrictions at an uneven and confusing pace depending mainly on the governor’s party affiliation, and people are coming back to formerly “non-essential” stores and jobs, hair salons (women are thanking God) and some restaurants. Flights are still 80% below capacity but on the way back up, and students are expecting to start school early in many places.

I do think there is a good bit of pent-up demand but that there are a lot of people who are going to take it slowly. And of course, 1/6 of workers have been without a job, though not totally without income. Not all of those will have jobs to come back to this year and that will certainly dampen consumer spending by quite a bit for the next few months and probably for a couple years or more. That’s why the best performing sectors of the market this year have been largely non-recessionary – tech, health care and energy (bouncing back from super-low oil prices.)

I do think the pullback today could be several percent for the overall market and double-digit percentages for the hottest stocks. We’ll have to see how things develop.