The Great Bond Rotation- 7 Bond Benefits
As the summer heats up, the stock market is experiencing its own heat wave in the form of rising volatility as the “everything rally” fueled by tech subsides. Just a couple days ago, stocks were celebrating the Fed’s discussion that rate cuts were arriving in September. A day later the VIX, often referred to as the market’s “fear index” doubled up to 23, while the CNN Fear & Greed Index needle ticked over to “Extreme Fear.” All this zigzagging of stocks and negative investor sentiment magnified by the media like an approaching hurricane could make your head spin.
Market participants, having been impatiently waiting for a rate cut since last October, responded this past week with a “buy the rumor, sell the fact” knee-jerk reaction. Tech stocks, which remain “priced for perfection,” have largely delivered disappointing results, further contributing to market volatility on top of faltering unemployment numbers and a slowing in global manufacturing. This all led investors to believe Fed Chair Powell’s rate cuts were going to be “late to the party” and that a hard landing may be in the tea leaves.
Jon here. As history rhymes and only sometimes repeats, this past week was a good reminder for investors that the last few times the Fed cut interest rates from their peak to initiate an easy money policy, a recession followed closely behind, so overall anxiety is not unexpected. Still, correlation does not imply causation and not every rate cut has historically led to a recession.
Mr. Market is Manic
Mr. Market’s reaction may be overly pessimistic and recognizes rising recession risks – but maintains that the odds remain low based on an overall slowing economy backed by a resilient consumer. This suggests a potential need for the Federal Reserve to consider either a continual rate cut program or even a half-point cut next month to stabilize the economy and give stocks and investors a good “jolt” of penicillin.
Mr. Market is a fictitious manic-depressive character described by Benjamin Graham in The Intelligent Investor. He points out with this metaphor that the price of a stock, or the stock market in general, can be moved quickly in the short term by emotions (humans) as much as facts. The prices Mr. Market quotes you on a daily basis provide minimal data about how well the underlying company (or stock market) is actually performing.
So how can you apply this to your own investment strategy? Graham, a mentor to the notorious Warren Buffett, teaches us to profit from market folly rather than participate in it. You can take advantage of Mr. Markets’ manic depression by buying stocks when he is depressed and selling to him when he is optimistic. This fits into the Buffett maxim to “to be fearful when others are greedy and to be greedy only when others are fearful.”
Bad News was Bad News
We are still confident about achieving a “soft landing,” where inflation slows without triggering a recession. Previously, bad economic news was viewed positively for stocks, as it reinforced the case for Fed rate cuts (where bad news was good news.) However, signs of consumer stress and a labor market showing cracks have altered this perception for now.
The recent selloff is more about a shift in investor behavior, magnified greatly by quant/ Ai trading mechanisms as we often discuss in extreme market conditions. There is, on average, a 14% pullback by stocks (S&P 500) every year regardless of the market cycle. For example, the accompanying chart below illustrates that even with the recent “great rotation” the largest decline this year has only been about 5.5%. This is quite low by historical standards, especially when compared to the strong year-to-date gains by the S&P 500 at nearly 12% YTD gains despite the April and July showers. Still, the notorious NADAQ tech index is down 10% in correction territory.
This highlights the importance of always being prepared for stock market volatility. Pullbacks are an unavoidable part of investing, especially with heightened event risk in the coming months. How investors deal with these risks is often far more important than the risks themselves. The current rotation to small caps and bonds to other undervalued sectors is also a reminder for investors to maintain diversification across a number of market areas, and not focus only on whatever is performing well or popular at the moment.
As is always the case, short-term pullbacks and market rotations are both normal and expected as investors evaluate new facts and data. Volatility is the price of admission, even for long term investors.
The Great Bond Rotation
WSJ reports when looking at mutual funds and ETFs together, taxable bond funds were responsible for nearly 90% of net U.S. fund inflows in the first half. Fixed-income ETFs collected more money than ever with a record $150 billion through late July.
If you are not in bonds – or don’t understand why disciplined investors of all ages utilize bonds as part of their asset allocation- give us a call – we can help! Bonds are not just for retirees! Note: The 60/40 is alive and well after a rough couple of years for fixed income and for diversified investors. Following the crowd and loading up on cash and or tech at the same time may not help meet your goals for the long run.
Bonds have suddenly become fashionable again with the Barclays Aggregate index shooting up nearly 4% for the past month while the S&P 500 and NASDAQ indices dropped down nearly 4% and 8% respectively. (See chart) This is quite the flip from bonds being in the red for the past year and both stock indices being up nearly 20%. Our balanced strategic portfolios held up near break-even for the past month signaling that diversification is doing its job in helping investors to minimize volatility.
S&P 500, NADAQ, Barclays Aggregate Bond Indices (bigcharts)
7 Factors to Hold Bonds
The data on cash flowing heavily into bonds suggests that investors of all ages and risk profiles are turning to bonds, not just retirees seeking income. This broader appeal underscores bonds’ role as a fundamental component of diversified investment portfolios inside and outside investors 401(K)’s and IRA’s after being hammered by inflation and high rates for the past five years.
Bonds play a crucial role in portfolio diversification and risk management, offering stability and income generation in volatile market conditions. The following seven factors are some reasons why disciplined investors incorporate bonds into their asset allocation strategies.
1 Risk Mitigation: Bonds traditionally exhibit lower volatility compared to stocks, providing a cushion during market downturns. This helps stabilize overall portfolio performance and reduces overall risk. In most bear markets and crashes, most bond indices actually go up, fueled by the inflow of buyers as well as from potential Fed rate cuts. Interest rates and bond values are inversely correlated like a seesaw. Soon may be a great time to barbell out into longer duration bonds that got crushed from the aggressive Fed rate hike cycle.
2 Income Generation: Bonds, especially corporate and municipal (tax free) bonds, offer regular interest payments (coupons) to investors. This predictable income stream can supplement other sources of income and enhance portfolio yield. You can make a similar or greater yield in high-grade short-term paper as in cash and money market instruments while benefiting from capital appreciation as yields decrease and cash vehicles become less favorable.
3 Financial Arbitrage: In a 60/40 balanced portfolio (by example) when bond funds are peaking during crashes and recessions, there is an opportunity to buy beat up stocks and stock funds at lower valuations while on sale. This form of rebalancing helps investors to follow the maxim to sell high and buy low.
4 Capital Preservation: Certain types of bonds, like U.S. Treasury securities, are considered safe-haven assets. They provide capital preservation benefits, particularly during economic uncertainty or periods of market stress.
5 Asset Class Resilience: Bonds have demonstrated resilience over time, offering a hedge against equity market volatility and economic uncertainties. This stability can help investors navigate various market environments.
6 Interest Rate Sensitivity: While rising interest rates can impact bond prices in the short term, diversified bond holdings can mitigate this risk. Strategic allocation to different types of bonds (e.g., short-term vs. long-term, corporate vs. government) can optimize risk-adjusted returns.
7 Investment Horizon: Investors with long-term financial goals, such as retirement planning or wealth preservation, benefit from the consistent income and risk management properties of bonds.
The bottom line: The recent great bond rotation, as highlighted by financial news sources, underscores the enduring appeal of fixed-income securities in diversified investment portfolios. Whether for income generation, risk mitigation, or capital preservation, bonds play a vital role in helping investors achieve their financial objectives across different market cycles. As such, understanding the strategic importance of bonds and their potential benefits can empower investors to make informed decisions aligned with their long-term financial goals.
If you’re considering how bonds can fit into your investment strategy or seeking to rebalance your portfolio amidst changing market dynamics, consulting with a financial advisor can provide personalized insights and guidance tailored to your specific needs and objectives. If you have any questions or are seeking a second opinion, please give us a call.
For more information on our firm or to request a complementary investment and retirement check-up with Jon W. Ulin, CFP®, please call us at (561) 210-7887 or email jon.ulin@ulinwealth.com.
Note: Diversification does not ensure a profit or guarantee against loss. You cannot invest directly in an index.
Information provided on tax and estate planning is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
You cannot invest directly in an index. Past performance is no guarantee of future returns. Diversification does not ensure a profit or guarantee against loss. All examples and charts shown are hypothetical used for illustrative purposes only and do not represent any actual investment. The information given herein is taken from sources that are believed to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as NewEdge Advisors, LLC does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors.
