New Market Highs? Interest Rate Fears? Now What?
In recent meetings with clients, the common question we hear is, “Where are we headed now that the markets have reached new all-time highs?” The obvious follow-up questions are: What are we going to do about it? Should we buy more? Should we sell? Should we take profits and head for the hills? These are all great questions and we hope the next few paragraphs will help answer them in both an interesting and understandable fashion.
All of the portfolios we manage, at their most rudimentary level, contain three basic asset categories: Cash, Bonds and Stocks. We manage both the risk and the opportunity of each portfolio by adjusting the amount of these categories and their underlying asset classes. The investment philosophy we operate under is that each of these categories will do well or poorly depending on where we are in the Economic Cycle. Therefore, before we make any adjustments to the mix of categories, we must first determine where we are in the Economic Cycle.
Let us look at the Economic Cycle chart below:
From a strictly U.S. economic perspective, there no signs of significant inflation and the Economic Indicators are continuing to move ahead, albeit slowly. This puts the U.S. somewhere between waypoint 2 and 3 on the Economic Cycle. At this point, Stocks still have plenty of room for long-term growth, as valuations are not too expensive, and earnings continue to grow. There may be any number of market pullbacks along the way, but there is little concern of a recession-driven bear market. Cash, although safe, produces little return as short-term rates are low (and are at record lows in this cycle) as the Federal Reserve (FED) is trying to provide stimulus to the domestic economy. Conversely, Bonds are the one asset category of concern. At some point in the not-too-distant future, the FED will have to become less accommodative, and interest rates will begin to rise.
So if bonds are the major concern at this point, what do we do with this side of the portfolio? We focus on two primary parameters of bonds: Quality (how good the credit-rating of the underlying bonds is) and Duration (how long it takes for the bonds to be repaid). Of these two, Duration is the most important feature in the portfolio in terms of risk[C1] exposure.
Generally, you would want to own long-duration bonds when interest rates are falling, as you would see increases in the underlying values of the bonds. However, when rates are rising, you want to own very short-term duration bonds that have little fluctuation. Shorter-term bonds will mature in short order and would then be replaced with the then current higher yielding bonds.
Accordingly, our analysis indicates that we are approaching a point in the economic cycle where interest rates will begin to rise. If the past is any indication, the FED will continue to raise rates until the onset of a recession, which we believe to be some years into the future. As such, we feel that it is both prudent and advisable to reduce the overall duration of the bond side of the portfolios.
Low interest rates are a current opportunity to your personal financial affairs in that it pays to be a borrower. It may work out that we will never again see interest rates for loans at these levels in our lifetime. It is our belief that the prudent use of loans for your financial objectives may be advisable. This may be one of the most opportune times to refinance your home loan, as the current mortgage loan interest rates can best be described as a bargain. Additionally, one can acquire a car loan at very low rates, and in some cases at a zero percent interest rate. The stress here is that it is the prudent use of loans where your financial situation warrants in concert with a balanced financial and investment plan.