If Stocks Are Expensive And Bonds Are Expensive, What Do You Do?

Traditionally, a balanced portfolio, with 60% equity and 40% fixed income assets was considered to be a pretty safe way to get long-term growth over multiple years at or about a total return of 7% annually on average (but certainly not guaranteed). Some years (like 2012) may get total returns in double digits, others like last year may be pretty flat. 2008 which frightened everyone, saw negative returns of about -15% or worse, depending on the structure of your portfolio.

The growth part of the portfolio, the equity portion is where the greater risk and potential volatility is supposed to be.

The fixed income, bond portion is supposed to provide the safety cushion.

In the long-term scheme of things, this balance works (or is supposed to work) because these two asset classes are normally negatively correlated, in other words when one is rising the other is falling.

Supposedly in stronger economic conditions, equity prices rise as do corporate earnings and as interest rates rise in those same circumstances, bond yields go up (with higher inflationary expectations) and bond prices fall.

However, my friends, these are not ordinary circumstances:

1) Economies have stagnated.

2) Earnings have not been growing, although stock prices have continued to rise.

3) Central banks have been keeping interest rates low in order to stimulate economic growth, but that has had limited effect.

4) Bond yields are "artificially" low and prices are therefore artificially high.

So you have a scenario where stock prices are probably too high and bond prices are also too high.

And as we have been talking about on our weekly webinars, the normally negative correlation is now a positive correlation.

This could all shift if economies start to grow again and corporate earnings reflect that and inflation returns and bond yields normalize.

However, the risk at the moment is that this scenario which we have been waiting to play out for a few years now, is not evolving that way.

We have become dependent upon the central banks to fix it, but they can only do so much.

Now it is up to the governments to make the fixes, but they are awash in debt and have limited resources to help out.

If bond markets fall and stock markets fall at the same time, the only place to turn (to avoid more than normal levels of volatility) are non-correlated assets (cash and cash equivalents are good non-correlated assets, among other things). 

It's worth thinking about.

The risk of greater volatility is out there and the traditional 60/40 portfolio maybe in for some turbulence.

We do have a tactical model with "other things" for our clients.

Feedback....scott@highrockcapital.ca

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bianca@highrockcapital.ca