Retirement Investing – Picking the Lesser of the Evils
When the Federal Reserve bailed out the banks, interest rates hit historic lows. Safe, good yielding fixed income investments disappeared. Investors were forced to put more of their capital at risk to earn a decent return.
A recent article by Matthew Kerkhoff in the Dow Theory Letters titled, “Where Did TINA Go?” grabbed my attention. The bailouts began almost a decade ago. Are investors still over the proverbial barrel? Now the Fed is raising interest rates, should we be rethinking our strategies?
Matt was fortunate to study under renowned expert, Richard Russell. His expertise is understanding the psychology of market participants and anticipating their behavior. Layering an element of behavioral science on top of technical and fundamental analysis provides a unique insight into market direction.
His column, “Matt’s Market Insights” offers a great perspective on what’s happening in the markets.
I asked Matt if he would consent to an interview, his thoughts about what lies ahead are something our readers will appreciate.
DENNIS: Matt, thank you for taking your time to educate our readers. Let’s get right to it. I’ll start with a two-part question.
Please explain what you mean by TINA. Do you feel anything has changed since the bank bailouts began?
MATT: Dennis, thanks for inviting me. TINA is an acronym developed after the financial crisis that stands for “There Is No Alternative.” The acronym is used as a narrative to explain why stocks have moved substantially higher in the years following the great recession.
TINA is an important concept to understand and relates directly to the fact that interest and deposit rates are at historical lows; frankly close to zero.
Bonds and cash, the primary alternatives to stocks, provide little to nothing in terms of return. As a result, investors have been forced to invest in the stock market in order to see any type of meaningful gain. The alternative of good yielding, safe income investments have been taken out of the market.
A lot has changed since the financial crisis, but importantly, two things have not changed – the deposit rate that savers earn on cash, and the yield that investment-grade bonds provide. Deposit rates remain essentially at zero, and the yield on the 10-year Treasury, a key benchmark, sits just over 2%.
This means that two of the primary conditions responsible for the big run-up in stocks over the past few years are still in place because the returns on alternative safe asset classes (bonds and cash) don’t keep up with inflation. TINA lives on…
DENNIS: While the interest on cash holdings is not keeping up with inflation, do you feel investors should be holding and/or accumulating cash?
MATT: Cash is an interesting topic from an investment perspective. The first thing I should mention is that keeping a large portion of your portfolio in cash is generally a bad idea. That’s because, as you mentioned, money held in cash earns no return and loses purchasing power to inflation over time.
With 2% inflation (the Fed’s target) the dollar loses half of its value every 35 years. Cash is fine for short periods of time, but generally, it is a poor store of value.
But cash does have other benefits. Namely, it has no volatility, and it’s the mechanism by which other investments are accumulated. Therefore, cash positions should be “managed” rather than avoided altogether.
Right now, we’re in the midst of a strong primary bull market. Economies around the world, including our own, are showing slow but sustainable growth, and this provides a great backdrop for stocks.
This is the type of environment that warrants having a low cash position, with the bulk of one’s investments focused on equities.
But that will change. Ultimately, our current situation will come to an end, and we’ll see the stock market top out on a longer-term basis. A variety of leading indicators will provide advance warning that this is occurring, and that will be the time to begin accumulating cash.
For now, enjoy the bull market!
DENNIS: Many investors are going to bond funds believing it’s safer because they are diversified.
The Fed is committed to continuing to not only raise interest rates but also reduce their holdings of government bonds – which will drive interest rates higher. Rising interest rates can have a dramatic effect on the bond market.
Matt, what advice do you have for those invested in bonds and bond funds?
MATT: Many investors are under the naïve assumption that bonds are “safe” while stocks are “risky.” In reality, this couldn’t be further from the truth, as bonds can lose value very quickly and for long periods of time.
Bond prices and interest rates share an inverse relationship. That is, when interest rates rise, bond prices fall. If interest rates do rise in the months and years ahead, many bond investors are going to see the value of their bond holdings plummet. This is known as “interest rate risk” and it’s perhaps the biggest risk that bond investors face.
BUT … there is a way to eliminate interest rate risk. The key to this lies in owning individual bonds and NOT bond funds.
DENNIS: Huh? Please explain what you mean.
MATT: When most people invest in bonds, they do so through bond funds. This is because the typical investor does not know how to purchase individual bonds.
Take a typical 401(k) as an example. Every fixed income option available through a traditional 401(k) plan is a bond fund, not actual bonds.
An investment into a bond fund behaves very differently from an investment into an actual bond. When you purchase individual bonds, you are guaranteed the return of your principal, assuming the issuer does not default.
This is not the case with bond funds. With bond funds, THERE IS NO GUARANTEED RETURN OF PRINCIPAL.
Let me repeat that just so we’re clear: The biggest benefit of owning high-grade bonds (nearly guaranteed return of principal) DOES NOT APPLY to bond funds. With bond funds, there is no guaranteed return of principal.
Instead, bond funds work more like ETFs, where the value of the bond portfolio is wrapped into the share price, which fluctuates heavily over time.
Two factors come into play. If interest rates rise, bond speculators may race for the exits causing the share price of the bond funds to drop. Depending on the type of fund, (longevity, bond rating etc.) some may be forced to sell some of their holdings at the worst possible time to meet redemptions.
The second factor is a bigger concern, applying to all bonds funds. The bond portfolio of a bond fund is valued on a mark-to-market basis. As interest rates rise, the market price of each of those bonds in the bond portfolio falls. As the price of all the bonds fall, the value of the entire portfolio falls, and the value of the bond fund falls with it.
This same thing happens to individual bonds (their current market value declines), but because the owner of an individual bond is guaranteed the return of principal, its “market value” doesn’t really matter as long as they hold it to maturity.
DENNIS: If the Fed continues to raise rates, it could put a drag on the economy, negatively affecting stock prices.
On the flip side, if interest rates rise, and billions of dollars move out of bond funds before the share prices decline further, where will that money go?
Could TINA come into play? Might much of that money be reinvested in the stock market moving it higher or preventing it from dropping?
MATT: There are many dynamics that come into play with regard to interest rates affecting stock prices, but in aggregate, here’s how it works:
Bonds act as competition to stocks when bond yields drop radically as they have, stocks tend to go up. When bond yields rise, we tend to see that the stock market sells off. This is especially evident in so-called “bond proxy” stocks. That includes things like the utilities, consumer staples, real estate trusts, etc.
The whole premise behind TINA is the lack of ability to find safe fixed-income investments with a decent return; thereby forcing many would-be bond investors into stocks.
When investors recognize they can unwind the TINA trade, and store more value in bonds because the yields for safe bonds are higher, money will flow back in that direction. If we do see interest rates normalize TINA will fade away as there WILL be an alternative to stocks.
However, for a variety of reasons, I don’t see rates heading substantially higher anytime soon. So for now, TINA remains a major narrative driving investor behavior.
DENNIS: Matthew, you have certainly given our readers much to think about, thank you for your time.
MATT: My pleasure Dennis
Dennis here. TINA is still with us. Yes, it angers many that the government forced investors to put more capital at risk in order to generate income. It’s a constant trade-off between seeking yield and preservation of capital. It’s no wonder pension funds are struggling and retirees are worried.
|Matthew Kerkhoff, like our friend Chuck Butler, writes a weekly column for The Dow Theory Letters. I’m very impressed with the quality of the research. They don’t offer a model portfolio; however, their individual analysts offer some well-researched (different and unique) stock recommendations. Just remember to use stop losses.
In addition, they provide a terrific guide for portfolio allocation. It is the first one I have seen that includes precious metals that I can comfortably endorse.
Please check them out.
They have offered Miller On The Money readers a special introductory discount – 10% discount off their 3-month trial, or 15% off a full year subscription.
I’m honored to have The Dow Theory Letters as one of our affiliates.
Their small referral fee helps offset our costs and allows us to keep our publication FREE. It’s a win/win for everyone.
On The Lighter Side
I read that the National Football League has seen their television ratings drop and they are concerned about empty seats in many stadiums.
Since the early days of satellite television, I have paid a few hundred dollars every season to watch my hometown team, the Bears. NFL football became a tradition. I canceled my subscription just before the season started.
What is it about the entertainment industry? Whether it’s sports, a play, movies, musicals, whatever; many now seem to have a political undertone. Maybe I am old-fashioned, but I look to entertainment as a vehicle to get away from the everyday problems for a few hours.
I don’t care what the message is; I don’t like it. Last season I was fed up with the lousy political commercials while trying to enjoy a game. If I want to watch political messages, there are plenty of channels to choose from. The clicker has an off button and it looks like many are using it!
Last week we had a fun visit from grandson Justin and his father Gary. Daughter Dawn stayed home in Atlanta and was without power for a few days because of the hurricane. Where would we be without cell phones that can be charged in the car?
While I was enjoying the week with my grandson, a graphic hit my inbox that grabbed me. Time with family is very special.
Until next time…