24 May 2013 The Trouble with Rising Markets
There is a danger in rising (and falling) markets that is so subtle we can easily overlook or ignore it. In fact, it is so integrally woven into our human fabric that separating the logical strands from the emotional ones is nearly impossible.
When markets rise for a period of time, we typically respond with varying degrees of emotion and logic. The daily, weekly, and monthly increases in wealth are exciting to watch. It is tempting to project the gains well into the future and begin dreaming bigger.
On the practical side, we know market rallies don’t last forever and we don’t want to miss the opportunities for the greater wealth they provide. The saying ‘make hay while the sun shines’ is time-tested and sage advice that implores us to gather our crops while conditions are favorable. The danger lies in being pulled from our long-term strategy by these short cycles.
We understand intellectually the danger of letting our emotions enter into investment decisions, but we forget just how powerful and deeply rooted the wiring goes. Perhaps more important, we often fail to recognize how effectively and subtly the media and financial industry use our emotions to influence decisions that we might not otherwise make.
When markets steadily rise or fall, a sort of drumbeat begins sounding in our heads that gains intensity as the trend continues. If we allow, it can gradually consume increasing amounts of our conscious thought. We begin asking ourselves and our financial advisors: is this a good time to buy more stocks, am I missing the boat, should I dump these low-yielding Treasuries to buy more stocks?
Along related lines, a friend recently asked my opinion of a five-year top-performing bond fund ETF called the SPDR® Barclays High Yield Bond ETF. His question provides an excellent example of a current phenomena driving this latest stock rally. It is in large part driven by the Federal Reserve to intentionally drive investors out of low-yielding bonds and into riskier assets like stocks and low quality bonds as they seek reasonable income and return.
The symbol of the Barclay’s High Yield Bond ETF symbol – “JNK” provides the first clue of risk as it clearly implies ‘junk,’ the industry term for lower quality, higher yielding corporate bonds. The bond ratings of junk bonds is below that of investment grade bonds or BBB, implying significantly greater doubt of repayment.
The fund’s 5% yield provides another indicator of its significant risk. High yield bondholders demand a premium to offset the risk they take of not getting repaid. That premium is determined through comparison to the yields of bonds that have no risk of repayment – US Treasuries. The average maturity of bonds in the Barclays HY index is 4 years. US Treasuries of the same maturity are currently yielding only .75%.
Anyone considering a junk bond portfolio (and to some extent a corporate bond fund) should also understand that the fund will behave more like stocks than bonds – in other words, it will be considerably more volatile and when stocks are going down, so will it. Intuitively this makes sense. If during weak economic times investors call into question the earnings of corporations, driving down their stocks, doesn’t it follow that payments on their bonds is also more doubtful?
But these generally aren’t the factors that attract or discourage investors from a particular investment. For reasons we have hinted at earlier and despite warnings that “past performance . . . is no guarantee of future results,” people all too often base their investment decisions on past results. Here are those of JNK.
The most likely buyers of JNK are investors who are seeking income. And as we have pointed out, that population has dramatically increased as Federal Reserve has driven income seekers from lower risk assets like Treasuries and government agency bonds into stocks and higher yielding bond funds like JNK.
To be sure, a yield of 5% and a five year total return of 8.98% sound quite attractive, but they don’t tell the story for most investors in the fund who buy it for income. So let’s take a look at what happens to returns when income is withdrawn from the fund over the 5-year period.
To provide some frame of reference, we will use our Risk Averse Model Portfolio as a comparison. It is the portfolio we use for many of our conservative income-oriented clients as we believe bonds alone do not provide for inflation. In our comparison, run on Morningstar’s database, we start with $100,000 invested in each portfolio on April 30, 2008. From each portfolio we withdraw roughly 4% or $330 per month for the 5-year comparison period.
Results of the study showed that the JNK did very well for the past five years with a return of 7.89% and an end value of $122,189. These results compare favorably to our risk Averse Portfolio which was up 6.16% and ended with $114,152, $8,037 less.
However, there’s a huge difference between the two portfolios that does not show up in the numbers mentioned before. Take a look at the two lines, JNK on the left and Risk Averse on the right and decide which one you would have been more comfortable with in 2008 and 2009.
Anyone drawing income from the JNK fund from April – December 2008 likely had many sleepless nights as they watched their principle drop by 24.4%. How much more likely do you think people in the Risk Averse portfolio with their 4.19% decline (same period) were to stick with their investment strategy? A high return on your money is not necessary when your money doesn’t leave in the first place.
At the conclusion of my report to my friend I told him that there was no way for me to answer his question about how well the fund would do in the future. Studies show that there is only a 14% chance that this fund will be in the top quartile of performers in the next five years. The downside risk outweighs the upside potential for return.
On the other hand, as long as the Fed continues to buy bonds and drive down interest rates, the stock market and the junk bond market have a safety net under them. But, safety net or not, risk is a silent time bomb and it has a way of going off at the least convenient of times. Better to avoid emotion and stick with your well-reasoned plan.