In the year following the collapse of Lehman Bros., the U.S. stock market lost a portfolio-wrecking 45 percent, and then bounced back 52 percent, leaving us about 17 percent down from where we were before the panic set in. The corporate bond market has also had a round-trip through the emergency room, leaving investors to wonder where we go from here. Was this another buy-on-the-dips opportunity? Or has the investing landscape fundamentally changed? No one knows for sure, but a consensus has developed that you should get used to what some pundits have dubbed "the new normal."
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To Bill Gross and Mohamed El-Erian, co-chief investment officer and CEO (respectively) of Pacific Investment Management Co., that phrase means a world with less borrowing, less globalization, and re-regulation. As you repair your personal balance sheet by slashing debt and boosting savings, you’re going to face an era of lower investment returns and economic growth as well as higher unemployment and inflation levels.
Most of us have come of age during the era that Ben Bernanke called “the Great Moderation.” Buying stocks and bonds whenever the market hiccupped, and then hanging onto those investments for the long haul was, as we were told over and over again, the only way to build wealth. So, too, was buying a home ― growth in the value of their primary residence helped countless Americans retire comfortably. Meanwhile, we turned to borrowing ― against our homes, or on credit cards ― to finance our needs and wants. The last leg of that stool has been cut off and burned, and now even the rest of the conventional wisdom may have to be tossed overboard in the new normal.
Things ‘Have to Change’
“A lot of things will have to change now that we have to recover after decades of being hooked on borrowing and leverage,” says Neil Hokanson, an investment adviser who works with well-heeled investors from his office in Southern California. One of those, he argues, is the idea that a good investment must be a stock or a bond, a mutual fund, or an exchange-traded fund (ETF).
“Why not a hot-dog stand or a bus shelter that has advertising on its side?” Hokanson suggests. “It’s only a matter of time before someone comes up with a way to create a security that gives its holders shares in a portfolio of Persian rugs.”
Now, if a broker calls you peddling carpet shares or billboard bonds, you should probably hang up immediately. But Hokanson is making a serious point: Slower growth leads to lower returns from financial assets. That leaves you with two choices: Either accept smaller gains (own index funds to keep costs from eating into your reduced returns), or reach for higher returns by looking further afield and thinking creatively. One of the types of investments that Hokanson believes could become the wave of the future is Macquarie Infrastructure Co. LLC, a limited partnership that owns a portfolio of interests in bridges, freeways, ports, and other infrastructure projects that generate income. Mexico’s Grupo Aeroportuario del Sureste (ASR) owns airports in the Cancun area and beyond. “We’re suggesting higher allocations to alternative asset classes as part of this trend,” adds Jeff Kleintop, chief market strategist at LPL Financial in Boston. “Commodities is one asset class that still fits the bill wonderfully, depending on what the specific market conditions are at the time you are looking for an alternative to the mainstream asset classes.”
The new normal also means it’s time to at least question traditional and established relationships between different asset classes. For instance, Treasury bonds offer lower yields and lower returns than corporate bonds, because of the government’s guarantee; in exchange for safety, investors tolerate lower returns. Similarly, stocks have tended to build wealth more rapidly than bonds, despite some lousy recent periods.
New Role for Corporate Bonds
Now those rules are at least being questioned. A few market observers are making the argument ― however preliminary and provocative ― that in the future corporate bonds could be seen as more secure than Treasury notes and thus offer lower yields, or that bonds may become the new stocks in terms of their role in an investor’s portfolio. What is certain, says Rob Arnott, chairman of Research Affiliates LLC, is that if you don’t question some of the canons that you grew up with during the “old normal,” you may end up suffering whiplash.
Arnott notes that, while the stock market has rebounded mightily since March, corporate bonds, which ought to benefit from the same economic outlook that helps stocks, are still cheap by historic standards. The yields on investment-grade (high-quality) corporate bonds now offer investors a 1.50 percentage point additional yield above historic averages; junk bonds offer one percentage point of extra yield. Stocks, meanwhile, are now more expensive relative to earnings than they have been over the past 30 years.
That leaves Arnott facing a conundrum: Either the world has changed, and bonds could emerge as the new high-risk but higher-earning asset class, or else this is just a temporary glitch and everything will go back to normal soon. (If the former, Arnott would hang on to bonds; if the latter, he would use any stock market sell-off to buy stocks cheaper.) While he’s skeptical that a massive upheaval in the traditional asset class relationship could be taking place, Arnott says that in the new normal that can’t be ruled out, and he warns investors against assuming that unfamiliar price relationships will automatically self-correct. “The new normal may indeed be that bonds are priced to offer superior long-term returns.”
In Hokanson’s eyes, the new normal could lead to a very unusual environment, one in which heavy borrowing by governments may make corporate bond issues seem safer than Treasuries. That would create a topsy-turvy world in which bonds issued by blue-chip corporations would pay lower interest rates than those issued by Uncle Sam. Hokanson admits it’s still an unlikely scenario, but it’s the kind of possibility that you have to consider in the new normal. And if he’s right, it means corporate bonds could be significantly undervalued right now.
Reconsidering Market Timing?
Above all, some investors say, the new normal means you will need to take a more dynamic approach to your portfolio, regardless of what asset classes you own. If the Pimco gurus are right, investment returns will be lower, and investors won’t be able to boost them artificially by borrowing in order to place a trade. Banks and other financial institutions simply won’t be lending for such speculative purposes. Not to mention, the returns of financial institutions — whose shares helped power the stock market to its 2007 high — will be lower if they can’t leverage up like they used to. That means that being in the right place at the right time takes on an added importance. To some, that’s known as “tactical asset allocation” — the ability to rebalance your portfolio to capture a short-lived opportunity or avoid what may prove a fleeting sell-off in one asset class. It’s what some investors did last fall, when they saw the outsize returns they could earn from investing in high-quality corporate bonds at the height of the credit crisis. Once bond prices rallied, they sold or cut back their positions, and went looking for other shorter-term opportunities.
Critics — including writers on this site — refer to that approach dismissively, as “market timing.” The problem is that while a few brilliant (or lucky) investors will make a lot of money quickly by capturing short-lived opportunities, more people will lose a lot of money by trying and failing. Even most pros fail at market timing. Nonetheless, a growing array of advocates say that “market timing” is a misleading label. “Market timing is about the market’s technical features — charts and trading patterns,” Kleintop explains. “Tacital asset allocation is about fundamentals — when you know that something has changed in the outlook for a stock, a sector, or an asset class that its prices don’t reflect yet.” You need to keep an eye open for those opportunities, which tend to arise suddenly and unexpectedly. Just beware of chasing winners — you’re looking for investments that will go up, not yesterday’s hot stock.
Look Outside the U.S.
So, how, exactly, do you invest in the slow-growth/high-unemployment world predicted by Gross and El-Erian? The goal is not just to recoup your recent losses, but also to keep your portfolio generating more return than inflation and higher taxes gobble up in the coming years. While there are few clear-cut strategies, you might follow the advice of the Pimco gurus and allocate a greater percentage of your investments outside the United States. Gross and El-Arian believe the U.S. dollar will lose its role as the world’s reserve currency as government debt soars. That means that the dollar is likely to fall against other major global currencies; if that happens, profits you earn in euros or yen will be worth more when exchanged for greenbacks.
One of the most popular foreign markets is China, where share prices have been on a tear this year. Gordon Fowler, chief investment officer of Glenmede Investment and Wealth Management in Philadelphia, believes that looking beyond our home market is a great way to identify new investment ideas, but is wary about the Chinese market, which he says is “richly valued.” China’s economy is very dependent on its exports to the United States, and anything that raises its costs or lowers U.S. demand could batter Chinese stocks. Paradoxically, he says, a spike in energy prices and a slump in consumer demand in the United States for Chinese products could make U.S. stocks more attractive than their Chinese counterparts, at least for a while.
In Pimco’s view, the new normal is a world of limited upside and a lot of uncertainty; a world in which you’ll have to be a more active investor — with, Pimco would argue, the help of your professional advisers — as you try to eke out a bit more return. The only certainty is that many of the old rules no longer apply, whether it’s buying on the dips, buying and holding, or assuming that stock and bond prices will always have the same relationship. “An investor’s edge isn’t going to be a stock tip or a trading strategy anymore,” argues Hokanson. “The successful investors are the people who are able to think most clearly and go beyond the status quo. They will be the next generation of Magellans and Columbuses, exploring a new world.”
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