As discussed at length, I have significant concerns about U.S. stock market valuations and what that may portend for the next bear market. After all, the most reliable valuation metrics are indicating the U.S. stock market is more expensive than ever before (including 1929 and 2000).
Although valuations aren’t useful for short-term trading, valuations do provide insight into the potential severity of the next downturn. So whether the next bear market has already kicked off with the January 26th peak or starts 12 months from now, the key to understand is it will likely be commensurate with the extremity of current valuations (i.e. severe).
A couple proactive approaches I’ve offered for consideration to preserve financial independence is either (1) under-weight U.S. stocks in favor of other asset classes, including bonds, and/or (2) incorporate “put options” to insulate portfolios from a significant stock market decline. Today, I’ll focus on what I’m doing within the bond sleeve of portfolios I manage.
Bond investments can be sliced and diced many ways. I’ll keep it very simple here. There are government bonds and there are corporate bonds. There are short-term bonds (bonds that mature within a few years) and there are long-term bonds (bonds that mature over ten years from now) and of course intermediate-term bonds maturing between 3 and 10 years. There are high-quality / investment-grade bonds (low risk of default) and there are high-yield / junk bonds (higher risk of default).
Because I believe we are very late in the economic and market cycles, I am avoiding high-yield / junk bond funds. The reason for this is that high-yield / junk bonds tend to be highly correlated with stocks especially when stocks are stressed. This means you don’t get the diversification benefits you need from your bond investments when you most need it because both high-yield bonds and stocks decline together. Investors need their bond portfolios to hold up well when stocks are declining. That is one of the primary reasons (in addition to income generation) for holding bonds in the first place! So it doesn’t make sense to take “equity-like” risk within the bond sleeve at this point in the cycle.
Over the last couple months, I’ve also gone so far as to shift away from investment-grade corporate bonds in favor of U.S. Treasury bonds. The result is a very high-quality bond sleeve with a heavy tilt to Treasuries. Treasuries tend to hold up much better than both high-yield and investment-grade corporate bonds when stocks are falling. In fact, in 2008, intermediate-term Treasuries actually made around 20% while stocks lost about 40% and high yield bonds lost about 25%. Even investment-grade corporate bonds only made about 2.5%. Treasuries were far more effective at hedging the decline in stocks.
Currently, I believe a lot of zombie corporations are being kept alive by easy monetary policy (e.g. low interest rates, QE) from the Federal Reserve, but those problems tend to be exposed as growth slows and interest rates rise.
As Warren Buffett has said, “you find out who’s swimming naked when the tide goes out.” My guess is there are a lot of companies and individuals swimming naked who will be exposed when this global flood of easy money recedes.
Let me know if you’d like a complimentary portfolio review where I can analyze your current holdings, risk and expenses and provide specific recommendations for changes.
You can find Part 2 of this topic here