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ALWAYS CONSULT YOUR INVESTMENT PROFESSIONAL BEFORE MAKING ANY INVESTMENT DECISION

October 18, 2019 | Danger, Danger

A best-selling Canadian author of 14 books on economic trends, real estate, the financial crisis, personal finance strategies, taxation and politics. Nationally-known speaker and lecturer on macroeconomics, the housing market and investment techniques. He is a licensed Investment Advisor with a fee-based, no-commission Toronto-based practice serving clients across Canada.

Sell. Sell everything except high quality bonds. This is about return of capital, not return on capital. In a crowded hall, exit doors are small. China has set off a major correction and it is going to snowball. Equities and credit have become very dangerous, and we have hardly even begun to retrace the ‘Goldilocks love-in’ of the last two years. Risks are high.

Now, relax.

Those words were a hoax. A marketing sham. Intended to gain exposure, notoriety and media exposure. And it worked. When analysts working at the Royal Bank of Scotland issued that report in January, 2016, it made global headlines and helped scare the poop out of millions of investors. Bad news sells. If you want attention, stand there and yell “Fire!”.

So what happened?

In January of that year the S&P 500 – the broadest measure of the world’s biggest equity market – sat at 1,918. Yesterday it closed at 2,998, for a gain of 56%. Oil, which RBS said was going to $16, trades at $54.

You might have noticed for all of 2019 analysts seeking attention have been warning of a recession. In that period of time the Dow is up 16% and Bay Street is ahead 15%. Investors in bonds have made a pile of money as rates fell and prices rose. US unemployment is at a 50-year low and Canada has created a record number of new jobs in the last year. And that’s despite a trade war, Brexit, Syria, Trump, Hong Kong, inverted yields and impeachment.

Investors or their advisors sitting on the sidelines in cash since 2016 have paid a huge price for their wussiness. Ditto those who believed the doomy talk a year ago. The best time to invest is when you have the money, and the best possible strategy (history tells us) is to stay invested.

Anyway, here’s the latest iteration of hellfire. This time from Bank of America Merrill Lynch.

Analysts there have just declared the most successful investing strategy of all time – the balanced portlfolio – as ‘dead.’ The rationale is that (a) US government bonds pay peanuts, (b) the negative correlation between stocks and bonds is breaking down and (c) there’s a bond bubble which will pop since too much money has gone into fixed income assets because of an aging population and slowing economy.

Their fix? Buy more stocks.

Is this smart advice? Have things changed so much in the past few months or years that a time-honored approach is kaput? Is it different this time?

Well, don’t get excited. Or scared.  First, the BoA guys are talking about a portfolio with a huge 40% bond weighting (twice what you should have) and comprised solely of US Treasuries (which you should not own). And second, it’s all about risk. By trying to reach for more return, they’re suggesting you stray into the red zone.

Let’s ask one of my fancy, suspender-snapping portfolio guys to comment. Here’s Sinan, who’s earned his stripes on both Wall and Bay Streets. So, what’s the message for investors?

“With the U.S. Treasury 10-year yield currently below 2% and many other government bonds in Europe and Japan yielding negative rates, it’s easy to question whether it still makes sense to hold 40% of a portfolio in bonds,” says Sinan. “However, as always, there remains a need for investors to control risk in a portfolio, especially those approaching and in retirement. Significantly increasing exposure to equities at this stage of the economic cycle and at current valuations substantially increases the risk of a portfolio.”

“Equity markets can be extremely volatile in the short-term and experiencing a significant decline over a short period of time is always a possibility. The future is uncertain and risks to the global economy are building so in our opinion it is very important to maintain balance between equities and bonds and diversification within both.

“There are alternatives to low yielding government bonds such as corporate bonds yielding 2-3% and preferred shares yielding close to 5%. Also, Canadian dividend paying prefs benefit from the dividend tax credit so on a bond equivalent basis the effective yield is over 6%. While corporate bonds and preferreds add credit risk to the fixed income portion of the portfolio they are less risky and less volatile than equities but offer yields in-line with dividend paying equities. The key is to build a well-diversified bond portfolio that includes the right mix of government bonds, corporate bonds and preferred shares while re-balancing periodically.

“Over the long term a balanced and globally diversified portfolio has grown at an average annual rate of ~7%. Currently, a well diversified 60-40 stock-bond portfolio yields ~3.5% which is in-line with higher yielding dividend paying equities but with substantially less risk. Most importantly, a balanced 60-40 stock-bond portfolio significantly improves the odds of not losing money over a 10 year period while still positioned to achieve solid growth above the rate of inflation. Most importantly, a well balanced portfolio provides a proven and disciplined system that keeps emotions in check. Often investors become overconfident and misjudge risk. They think they’ve identified trends which often turn out to be expensive assumptions.  Don’t abandon a proven system that has worked over the last several decades.

“Imagine you took the advice of the Merrill Lynch strategists and substantially increased your exposure to dividend paying equities.  You expect to earn 10% a year vs a 60-40 stock-bond portfolio delivering 5%. Unfortunately, your timing is off and you pay too high a valuation for the equities as the economy contracts more than expected and equity markets lose half their value within the first year (highly unlikely, but just an example). Your reduced bond exposure is no longer large enough to help offset the significant decline in the equity allocation. The equity market finally finds a bottom and starts to recover but even if the suggested portfolio of ‘more dividend paying stocks and less bonds’ generates twice the return of a balanced and diversified 60-40 portfolio, it will take you more than 16 years to overtake the balanced portfolio simply because you paid too much and lost too much. This is not the time to substantially increase risk in an attempt to earn a little more because bond yields have dropped and the negative correlation between bonds and equities has recently declined. “

Exactly. Investors should have two goals: (a) don’t lose money and (b) get a reasonable rate of return. Swallowing more risk to enhance returns means you increase the odds of failing both tests. Meanwhile emotion makes folks do weird things – buying stuff that goes up and selling at a loss.

Then there’s this danger: listening to people who make money when you get excited and trade. Like the banks. And the brokerages. And advisors paid on transactions.

Turn off BNN. Go walk the dog. It’s all good.

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October 18th, 2019

Posted In: The Greater Fool

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