The Great Plains. Photo: Doug Stremel. Source: Wikipedia. CC BY 2.0
“Toto, I have a feeling we’re not in Kansas anymore.”
That’s what Dorothy says to her little dog when she first steps into the new land of Oz. Her grey, smashed house lies in the background; bright flowers, fountains, and singing birds are in the foreground. My dad told me about when the film first came out in 1939. As Dorothy steps out of her drab black-and-white origins into the vibrant technicolor landscape, the theater audience gasped. It was palpable. In the movie, the dramatic colors indicated a dramatic, new reality. New rules applied in Oz: singing munchkins, talking scarecrows, and cowardly lions would show Dorothy how to get home.
We’re not in Kansas anymore in the markets, today. Recent developments — the pandemic, demographic pressures, a technological revolution, and central banks around the world committed to a zero-interest rate policy for “as long as it takes” — have shaken investing fundamentals to their very core.
Note: the foundations haven’t changed. Securities are still valued based on the present value of future cash flows. The stability and duration of those cash flows will determine the level and volatility of their respective asset prices. Capital will still seek returns. All these verities are still crucial to managing our wealth profitably in both good and challenging times.
But the policy changes put in place over the past several months mean that we need to re-think how we allocate our funds. Investing has always been a balancing act: investors need to consider growth, stabiliy, and liquidity of their holdings. Here’s a table for the most popular assets:
A liquid asset is one that can easily be converted into ready cash, cash that can be used to pay bills or to reallocate to another asset. Stocks and bonds can easily be sold, under almost any conditions, and the cash can be wired almost anywhere. To sell real estate or a private business interest, we need to list with a broker, a sale must be arranged, and a legal closing has to take place. The process can take months, or longer.
That’s one reason why bonds have been such a popular investment over the years, despite the fact that they almost always return less than stocks. And the reason they do is fundamental. Bonds are a senior claim on a company’s cashflow and balance sheet. If a firm gets in trouble, the bondholders get paid first. Shareholders are paid last, which is why they benefit from the growth of the business. But even though their returns are modest, they enjoy high liquidity.
But in our current situation, bonds can’t be considered medium growth instruments. In fact, they often yield less than bank deposits. Here’s a picture of the yield on 10-year US Treasury Notes over the past 50 years:
10-year US Treasury Note Yield. Source: Bloomberg
What a trip that’s been! From 14% in 1980 to 0.67% today. For years, pundits have declared the end of the bull market in bonds. And those pundits have been wrong. But even if yields on US Treasuries go negative – something that the Fed is reluctant to support – they can’t go *very* negative. Even the most deflationary economies still yield more than -1.00%. This means that bonds are no longer a moderate source of growth – they have to be considered “Low Growth.” And they don’t provide as much diversification benefit, either.
Traditionally, if you held both stocks and bonds, the bonds would go up in price if the stocks fell. That’s because, in an economic downturn, stocks would fall because of the greater uncertainty associated with their cash flows. But the slower economy would mean that interest rates would fall, and the present value of the cash flows associated with safer bonds would rise. So rising bonds would (partially) counteract falling stock prices, and our portfolios wouldn’t go down as much.
But in a nearly-permanent zero interest rate regime – around the world – that’s not an option anymore. Over 80% of all the bonds issued around the world yield less than 1%. The only place people can go to find bonds that yield much more than that entails taking significant credit risk: such as airline bonds, or bonds issued by Emerging Economies, like Russia or Lebanon.
Negative 10-yr Interest Rates in Europe. Source: Bloomberg
What should investors do when the world changes? We need to look at alternatives. The fundamentals haven’t changed, but their application has. There are still vehicles in which we can invest that provide income, liquidity, return, and diversification. But they involve understanding different legal structures that have their own specific issues. There will be a lot of homework. And there will be a test, or rather, lots of tests.
At the end of “The Wizard of Oz,” Dorothy gets home. But she has to learn a lot and grow up in the process. That’s what we all have to do. We’re not in Kansas anymore.
Judy Garland and Toto. Source: Wikipedia. Public Domain.