Navigating Clients Through a World of Extremes
By Tom Wall
It was several years ago, and I was getting in the car to drive well over 300 miles to upstate NY. On any normal day I would typically set my cruise control to 80 and drift off into my thoughts, letting my instincts and the car’s technology take over. I had made the drive countless times before, but this was no normal day. More on that later.
As financial advisors, our job is not to time the markets or make predictions about the future. History has repeatedly shown that to be a fool’s errand, and mistakes can compound at incredible cost. Instead, our goal is to educate clients about the wealth-creating potential of various asset classes and match their risk tolerance to a properly allocated and diversified portfolio. Over long periods of time, this approach has been shown to work best for most clients.
That said, we are living through a time of extremes. Equity values are nearly at all-time highs by commonly agreed upon metrics. The “Schiller PE” or the CAPE Ratio has only been higher once, and that was at the heights of the dot-com bubble. This metric compares the price of the broad stock market against inflation-adjusted earnings over the last 10 years. Its critics will say it has been a poor indicator of what’s to come the following year, so one should proceed with caution if using it to make short-term predictions. However, it has been an incredibly strong indicator of what’s to come over the subsequent decade. Many of the world’s leading investment managers have ratcheted down expectations of future returns due to this. Investor beware.
Interest rates have simultaneously never been lower, and one would have to go back over 80 years to find a similar environment. This obviously threatens savings, but it has also resulted in a frothy bond market as rates have decreased. There are two ways you earn money by investing in bonds. The first is through the coupon payment of the bonds, also known as interest. The second way, which is often less appreciated by common investors, is through capital appreciation or depreciation. In a rising interest rate environment, bonds that you hold become less valuable because the interest you’re earning becomes less than one could obtain on the open market. If you want to sell your bonds, you’ll have to do so at a discount because yours have lower cash flows than available elsewhere. On the other hand, in a decreasing interest rate environment, the value of your bonds may rise significantly. Since the early 1980’s, we witnessed exactly that for four decades, marking the biggest bull market in bonds we’ve ever seen. Bond billionaires were created during this time, not because they were particularly skilled, but because decreasing interest rates created a no-lose environment.
In the chart below, you can see two distinct 40-year periods of time. Each environment, on average, had about the same interest rates on the 10-Year treasury, a commonly referenced benchmark for interest rates. However, an investor in long-term corporate bonds over each period would have experienced wildly different outcomes based on the direction of the change in those rates over time. Since 1981, investors enjoyed a period that not only returned them over 10%, but also had very little volatility – they would have had losing years in bonds only once every 10 years. Prior to 1981, however, that investor would have earned only 2.89% and lost money nearly a quarter of the time. Few bond investors today either recall this period of time, or are adequately aware of these risks. The problem today is that rates (over time) can really only do two things. First, they can remain low, in which case investors won’t see much price volatility but they’ll continue to earn very little interest. Lots of smart people, myself included, continue to predict this outcome. Alternatively, rates could rise, presumably to fight inflation as the Fed did following the 1970’s. Inflation hit its highest levels in 40 years in 2021 and has continued into this year. Jerome Powell, the Fed chairman, has already stated the fed’s intention to raise rates in the short term. And as they say, don’t fight the Fed. If this occurs, capital depreciation will offset interest (at best) and you’ll get mediocre total returns, but increased volatility (at worst) could result in greater or more frequent losses than most bond investors understand are possible.
Source: Duff & Phelps SBBI 2021
So, what’s an advisor to do? How do we add value while remaining principled investors?
Well, what if there was a vehicle you could add to one’s portfolio that was guaranteed to only go up in value? That would allow one to remain invested elsewhere with greater comfort, knowing at least a portion of their portfolio was rising no matter what.
If that vehicle could offer bond-like returns over time, but perform better as interest rates rise, it could potentially be a strong diversifier of your clients’ fixed-income and cash allocations. Particularly if one could access that vehicle’s value at any time without restriction.
What if that same vehicle had special tax privileges granted by Congress, allowing one to multiply money over time and not owe the IRS a dime of the growth? That could help reduce taxes over time – something all our clients are asking us to help them do.
And wouldn’t it be cool if the investor happened to die or became disabled along the way, this vehicle would self-complete and pay a lump sum to loved ones at death or make contributions on their behalf while disabled? This would ensure goals are met, no matter what.
Ok, back to my 300-mile drive. I was low on fuel, but the sun was shining, music blaring, and clear roads ahead. I'd push it so I wouldn't have to stop too often. But after a couple of hours into the drive the skies got dark. It was winter, and in upstate NY, you don’t mess with potential “lake-effect” snowstorms. Knowing I needed to get to my destination by that night, I quickly pulled off the road, fueled up the car, and after checking the weather, realized I was in for a long drive ahead and bought provisions. As the flakes began to fly, I backed off my normal cruise control levels, pointed my tires into the tracks of the trucks ahead, and paid attention. Along the way I witnessed multiple cars speed past me and slide off the road. It was scary. Others had obviously done so soon before, and the snow had begun to pile up around them. I later learned that some people were stuck in their cars for almost a whole day, with nowhere to turn in a remote area during a major storm. To drive like I normally would have, like them, with full awareness of the environmental risks, would have been reckless. That storm delivered almost 3 feet of snow and was one of the biggest on recent record - ignoring its potential could have been catastrophic, as it was for many drivers that day.
Are your clients blindly marching toward retirement without any consideration of the current conditions and the risks they present? Could this be your time to shine as a trusted advisor, helping them get prepared while staying the course? Let your clients in on the best kept secret in the business, and give them the freedom and comfort to stay the course.
- Tom Wall
