Reading Tea Leaves and Billboards
There is abundant evidence that investors should approach market timing with restraint.
Rather than nodding off through a recounting of historical studies, we can just think about the basics of market movements: the more people want to buy, the higher the market goes and vice versa. Sometimes for very good reason, sometimes not.
February of 2000 was not characterized by most people wanting to sell. It was characterized by people seeing their neighbors get rich off stupid ideas and wanting to get a piece of the action.
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The excess of yesteryear sounds silly and easy to avoid, but the dot com burst came over three years after Alan Greenspan described the stock market as “irrationally exuberant” and likely to provide lower long-term returns. And over the long-term, Greenspan was right – both the Nasdaq and S&P 500 provided meager returns through the early 2010 decade.
But the three years following his comment saw the Nasdaq triple and the S&P 500 double before falling back to earth. Greenspan’s experience lines up with the data – the shorter the timeframe, the more unpredictable the stock market’s returns.
Similar to the time of Greenspan’s 1996 speech, many valuation metrics today suggest lower than average long-term returns. These metrics include credit spreads and ratios of broad stock prices to long-term earnings, revenues and economic output. Some market strategists point out more anecdotal evidence, such as the prevalence of meme stocks, “back-door” IPOs and cryptocurrencies.
Like Greenspan, most of us would do better to try our hand at reading tea leaves than guessing whether our life’s savings will double before some irrational madness comes to an unsightly end. There is better evidence suggesting investors stick to a disciplined diversified strategy that will protect them from the full brunt of an inevitable stock market downturn while also participating in an environment of wealth creation (and avoiding the pain of completely missing out).
That said, there are other risks that diversified investors can shed completely in the current environment without fear of missing out on much. While stocks don’t advertise their maximum return, the fixed rates on most bonds might as well be a billboard.
Traditional high-quality bonds are often used to lower portfolio risk by acting as a ballast for an investor’s portfolio and providing a more predictable source of cash than stocks.
Alternatively, investors buy junk bonds in hopes of earning returns closer to stocks. Like stocks they have considerably more risk than high quality bonds. For example, junk bonds plunged as much as stocks in the global financial crisis.
Another measure of risk in junk bonds is defaults or missed payments. BB bonds, the best rated junk bonds, historically average over 10% cumulative defaults within the first five years of issuance according to a 2006 study by Moody’s, a credit rating agency.
If investors were to sell junk bonds now, they would avoid the risks noted previously while in some cases also converting future ordinary income into long-term capital gains for preferential tax treatment.
Avoiding an assets risk means also avoiding the return.
Junk bonds are sometimes called “high yield bonds,” but today that reads like the greatest case of false advertising since the Orinda Theatre featured The Never Ending Story. Junk bonds are at their lowest-ever yield. For BB-rated bonds that yield is about 3.13% (ICE BofA BB US High Yield Index Effective Yield) as of press time.
That means if you boot these out of your portfolio for something sturdier, the most you can miss out on is 3.13% per year in a hypothetical world where junk bonds never lose value or default – an unlikely scenario that simply doesn’t seem to merit the risk.