Kensington Wealth Advisors August Re-Cap

Recap: The stock market has been making record highs and government bond yields have moved lower from their peaks earlier this year. Typically, bond rates climb when growth is improving and inflation begins to accelerate.  The Fed this year has raised short-term interest rates which usually follows an increase in long-term rates. The yield on the 10-year Treasury, which spiked after the election went as high as 2.62% in March and has since fallen to around 2.2%, with the low 1.37% established in July of 2016.

Link to September FOMC Statement: https://www.federalreserve.gov/newsevents/pressreleases/monetary20170920a.htm

As expected, the Fed opted to keep rates unchanged on September 20th’s announcement at a range of 1.00%-1.25%, as it has since the June FOMC meeting. Furthermore, the Fed continues to expect a “gradual” rise in rates, leaving the option of a December increase on the table.

The FOMC announced that it will begin to taper reinvestment in October in an attempt to reduce the size of the Fed’s $4.5 trillion balance sheet.

The Fed’s continued positive assessment of the U.S. economy has prompted the unanimous decision to move forward with balance sheet reduction. According to the Summary of Economic Projections, the Committee anticipates inflation to reach and sustain a 2% level by 2019 amid an improved growth profile of 2.4% for 2017 GDP and 2.1% for 2018. Additionally, assuming the economy continues to evolve in line with officials’ projections, the Committee continues to anticipate one additional rate increase this year (December) and three quarter-point rate increases next year, the same number reported in the June SEP.

As expected, the Fed opted to take a pause in the “gradual” pathway in raising rates only to announce a second layer of policy accommodation removal.

Other considerations for the Fed officials include a slower-than-expected pace of inflation – barring temporary disruptions from Hurricanes Harvey and Irma – as well as weaker-than-expected support in the economy from a still lackluster labor market, modest wage growth, and tepid manufacturing activity, not to mention rising tensions abroad and geopolitics risks. Any signs of a more muted reality than that projected by the Fed will present a difficult scenario for the market; should the Fed continue along the intended pathway to higher rates with evidence of a less than robust domestic recovery, the longer-end of the curve should remain restrained, resulting in an increasingly flattening of that curve.

 Buy Bonds Not Stocks?? Really???

Given the possibility of a stall in economy, is it prudent to position stock or bond portfolios, or both, as a defensive posture? Outlined ahead is a common method which helps to identify when there is excess return in stocks or bonds relative to risk. Called “Warren Buffett’s favorite valuation metric,” the market cap to GDP ratio takes the cumulative market cap of the Wilshire 5000 stock index divided by the current GDP. This ratio gives you an idea of how the valuation of stocks is growing relative to the overall economy. Higher ratios indicate higher valuations for stock prices.

Market-Cap to GDP Ratio: (Source: Ycharts)

 

Regression:

(Source: Ycharts)

To visualize this correlation take the ” Y = ” formula in the chart above to imply future 10-year annualized stock returns based on today’s market cap to GDP. The plotted implied returns (calculated with the y= formula above) and the actual 10 year annualized returns are shown below:

Implied 10 Year Annualized Return Vs. Actual Return:

 

This chart shows what return you can expect over the next 10 years based on the valuation at which you bought stocks.

 

The chart implies your return to be over 12% annualized had you purchased stocks in 2009. That said, buying stocks at current valuations does not offer as promising returns over the next 10 years. The only time a lower return was implied was when this metric properly warned of the future returns for stocks during the dot-com bubble.

From 1997-2001, this metric implied negative returns for stocks. This ultimately came to fruition, but for the first 3 years, you certainly looked foolish for being out of the market. However, after the mean reversion occurred, you looked quite smart to be out of stocks.

Utilizing this metric will ensure you are not fully invested at market peaks and will give you a reasonable opportunity to add to establish new positions at lower levels. However, you will likely under-perform during the last 1-2 years of a bull market. Behavioral finance and studies suggest the majority of investors do not exit at market tops, in fact quite the opposite.

If the expected return for stocks is greater than the 10-year interest rate, be overweight stocks. If the expected return for stocks is below the 10-year treasury rate, be overweight bonds. The mapped 10-year expected return for stocks against the 10-year interest rate is below. You can see the years that you would have been overweight bonds (when the red line is above the black line).

Implied Return Vs. 10 Year Treasury Rate:

(Source: Ycharts)

The chart below shows the lowest exposure to equities in March 2000 and the highest exposure to equities in March 2009.

Implied Stock Allocation:

Given this study, current numbers are suggesting an under-weighted allocation to stocks due to lower expected returns over the next 10 years and as well as the relative expected return on stocks compared to the 10-year interest rate.

Although it can be hard to be underweight stocks as the market continues to run higher, the data shows it may be your best bet.

A major benefit of being a systematic manager is that we take and process a large pool of information which looks far beyond the single valuation techniques described in the above example. We look to the credit markets and add technical overlays which act to monitor market movement. This methodology eliminates bias, emotions and guessing with respect to decision making.  It keeps clients invested when favorable risk metrics allow. Historically, in the commencement of fed tightening the high yield bond market initially moves higher and with the equity markets.

When a tactical overlay strategy, applied to the corporate high yield marketplace, triggers to exit alert and a trend fades and reverts to a risk off allocation to either cash or treasuries, standard deviation can be tamed to a third of that of The S&P 500 with near comparable annualized returns.

Deploying a risk on/ risk off methodology allows for a smoother return profile when utilizing the corporate high yield bonds. A simple buy and hold approach within both sectors demonstrates the S&P 500 (NYSEARCA:SPY) has outperformed the corporate high yield over this  sample period, but has done so with 55% more risk as measured by the standard deviation of quarterly returns. Let’s look at a histogram of quarterly returns for both stocks and high yield bonds to understand the relative riskiness better.

The return of corporate high yield bonds is much more likely to be clustered around the mean and less likely to produce returns at the extremes.

 

History has shown that the Corporate High yield market produce less variable returns than the equity market. Notwithstanding, from time to time, the Corporate High yield sector can under-perform the equity market and recognizing these inflection points and knowing when to step to the sidelines is paramount protecting capital and allowing for steady, consistent compounding of returns.

**Excerpts taken from original article written by: Eric Basmajian, research analyst, Long/short equity, long-term horizon, https://seekingalpha.com/author/eric-basmajian/articles#regular_articles