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Risk Continues To Be a Four-Letter Word; You Should Continue to Avoid It

There are opportunities out there, an optimist would say. The question is, however, how much added risk are you willing to bear to seize them? The following represents my point of view; others may answer the question differently.

In short, my answer is to limit your risk. Since we first discussed the possibility of a bear market a year ago (see "2007 Returns Show Potential Warning Signs of a Bear Market"), things have only gotten worse and worse. Almost everybody failed to foresee the seriousness of the situation. And even now, almost no one is visualizing that yet another, and possibly even bigger shoe, may be waiting to drop.

A pessimist, I am not. But having a face-to-face confrontation with a worldwide situation seemingly losing its bearings more and more each new day, is not a challenge I am willing to fly in the face of.

There are those who may cut and run (or already have). Who knows? Maybe their actions will be proven correct. But while I don't currently plan to take on any new risks, I will not throw away my prior choices. (To see our prior and current Model Portfolios, and some contrasting thoughts, please go to my website at http://funds-newsletter.com). A sound plan may encounter many potholes, but the road is still worth taking. I have yet to hear an alternative route without serious potholes of its own.

How deeply do we put ourselves in harm's way? The man who invested his life savings into horse and buggies was likely wiped out when automobiles came along. (And the man with his life savings in General Motors stock had better be on guard too.) But what about those who choose to invest almost solely in stocks? These have not been good times for those so committed. Ten years running with virtually no results for the average US stock, while not a death knoll, suggests a single-minded path may not always be the wisest.

So where can one smooth over the bumps while the world, first, staggers and then likely, stagnates? Under a mattress, in money market accounts or CDs? Only if one wants a repository to store money. Why cash is seen as the place to hide befuddles me even more now that cash rates of return are set to drop to being nearly invisible.

So instead, my answer is my old, but generally unloved friend, bonds - see "No Bull? Bonds Can Trounce Stocks (and Beat Cash Too)" in my Apr. '08 Newsletter. Since that date, investors might be sitting on about a 10% bond fund gain vs. around a 2% gain in cash and a 30% loss in a typical stock.

And with nothing but bad news projected to lie ahead for the world, the gains should continue to be there for well-chosen bond funds, which can be more than just a repository. For example, the 1 year return on the Intermediate Term Govt fund we recommended in Apr. (Vanguard VFITX) is currently about 14.9%; for the Long Term Govt fund (Vanguard VUSTX) also recommended then, it's about 25.2% (data thru 12-29-08).

So, here's my advice. Stick with the stocks you still have (unless you have no choice but to raise cash). And be mentally prepared for the reasonably good possibility, although not certainty, that even worse performance lies ahead; stocks could continue to drop significantly although they will come back to reward investors given enough time. But for the foreseeable future, become a heavy-duty bond investor (at least until inflation as measured by the Consumer Price Index returns to a more normal level of about 2% to 3% - it's currently at 1.1% and likely to drop more in the months ahead).

The horse and buggy may be dead, and maybe even American car companies. But merely staying in one stationary place isn't a viable model for either people or investors. As interest rates and inflation fall around the world, getting a positive rate of return from existing bonds will become more and more desired by investors. As a result, you will most likely get not only a fixed yield, but capital appreciation as more people will want to own the currently best performing asset class around.

The last time we were more bullish on bonds than stocks was in our Apr. 2, 2003 newsletter. On that date, the S&P 500 Index closed at 881. As of Dec. 29, approaching 6 yrs later, the S&P closed at 869, approximately a 0% return. For comparison, the Vanguard Total Bond Market Index returned approx. 4.7% annually over those same dates.

Among the myriad of reasons I am so bullish on bonds is this: In Feb. 1999, the Bank of Japan dropped short-term interest rates to near zero, just as the Fed did this Dec., both in an attempt to fight deflation. Ditto for back in June 2003 when the Fed dropped its short term rate to 1%, which to that point, was an historical low. Deflation, inflation's opposite, is public enemy no. 1 (it occurred during the Great Depression). Once started, it is hard to stop (Japan had non-stop deflation between 1999 and 2006.)

What were the effects of these rate cuts on inflation? In Japan, over the following 3 yrs., the already low inflation rate did not stop falling and annualized deflation greater than -1.5% set in. In the US, the inflation rate also continued to drop after the 2003 cut for the better part of a year. But by the latter part of 2006, inflation, as was the case in Japan, was also lower than before the Fed's historic cut, although not in deflation. All this suggests that it will take a considerable amount of time before inflation stops falling and possibly begins to rise again.

Incidentally, what specifically is the Fed (not to mention other central banks) trying to accomplish by pulling out all the stops as it announced it was going to do in December? Of course, dropping interest rates is designed to make it easier for consumers to borrow and spend, which would help foster growth. But, although I can't prove it as I have no access to the Fed's inner deliberations any more than anyone else, it is likely they also have the following goals in mind:

  • They want you to get out of money market accounts and CDs. Why? Because in order to get the economy, and esp. the housing market back on its feet, they want investors to continue to buy bonds which, upon comparison, will be seen to still offer somewhat better yields. The more bonds that are newly purchased (or bond funds), the lower intermediate and long-term rates will go (short-term rates can hardly go lower), helping to more quickly reverse the housing market's slide. And if investors decide to buy stocks instead, that too is a plus for the beleaguered stock market and economy as well.

  • The government is in the process of borrowing more and more to pay for the various stimulus packages/bailouts. The lower the rates they have to borrow at, the less the cost to be added to the already staggering deficit.

  • They would like to see the dollar fall even further which usually is a side-effect of lowering interest rates below those of our trading partners. The lower the dollar, the cheaper and more competitive our exports to those countries become, creating greater demand for our exports. Perhaps even more important, at the same time, a lower dollar helps to create a little more inflation here at home. A little more inflation would be welcome news to the Fed. Since the Fed dropped rates to 1.0% in late Oct., the dollar has fallen significantly.

    Fed chairman Ben Bernanke noted this link this back in 2002, as recently was pointed out in the Wall St. Journal: The devaluation of the dollar in 1933/1934 "ended the U.S. deflation remarkably quickly," he said. (Note: If the dollar continues to decline, this will once again be helpful to US investors who invest both in (unhedged) international stock and international bond funds.)

While bonds will likely not be the best investment for the next 10 years, as they have been the last decade, we expect the good performance to last for at least a year longer. But you should continue to stick to high quality bond funds as described in our Oct 08 newsletter; while there may be considerable opportunity for those who choose to invest in riskier high yield and long-term corporate bonds, we think it more prudent to await real signs of a recovery before committing.

As to whether government bond funds are in a bubble, I do not see the kind of "overheated" returns over the last 3, 5, or 10 years that jump out as obvious warning signs that investors have overcommitted to bonds. In fact, long-term "investor returns" (as defined by morningstar.com) in even the highly rated Vanguard Long Term Treasury fund are not really any different than the returns seen during other previous periods of slow growth.

 

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