Investing in a High-Yield World
The Return of Optimism
Year-to-date, the S&P 500 is up 13% and 10-Year U.S. Treasuries are up 15%.
This is a welcome change from last year, when both stocks and bonds corrected sharply. Historically, the relative stability of bond prices provided effective protection against the inherent volatility of stocks. However, 2022 was the first time in nearly 50 years that both asset classes crashed simultaneously.
How much longer should investors stay in this safe haven?
Understandably, that unexpected turbulence encouraged capital to flow out of stocks and bonds and into money market funds and high-interest savings accounts. As of Sept. 6th, 2023, the Investment Company Institute reported that money market funds’ assets stood at an all-time high of $5.6trillion.
As the Federal Reserve hesitates to continue increasing interest rates, historical data suggests that now may be the perfect time to rotate back into stocks and bonds.
The Dangers of Cash
The positive outcome of the Federal Reserve’s aggressive interest rate increases is that no-risk investments are finally offering attractive yields. For example, savings accounts and money market funds are generating 5%+ returns. This was unthinkable just a few years ago.
Most investors dislike uncertainty and volatility. When the markets go down, they pull their money out and seek safety. When the markets bounce back, they inject capital back into risk assets. At writing, these risk-averse investors are sitting in cash waiting for the market conditions to improve.
Unfortunately, studies have conclusively demonstrated that this is a losing strategy.
Investors who stay invested during all market cycles generate better returns than investors who try to exit and reenter the market at the ‘best time’. This is true over short, medium, and long-term horizons – timing the market simply does not work.
Furthermore, data also suggests that staying invested in cash when the Federal Reserve is nearing the end of a rate hike is a losing proposition. From1995 to 2018, bonds, balanced portfolios, and stocks have always outperformed cash in the 1-5 years following the final rate hikes.
How can stocks outperform cash in a high yield environment?
When the Fed stops raising rates, the cost of credit stabilizes and eventually declines. This allows firms and consumers to invest and consume again, which boosts the economy and corporate profits.
Logically, more economic activity benefits stocks, albeit not equally.
Beware the Market’s “Bad Breadth”
Did you know that since the start of 2023, Apple, Microsoft, Amazon, Alphabet, Tesla, NVIDIA, and Meta accounted for more than 70% of the S&P500’s total gains?
The U.S. stock markets are showing signs of extreme concentration that are very concerning.
This concentration showcases the disconnect between the tech behemoths and the rest of the market. The dominance of these companies creates a self-reinforcing dynamic that pushes their valuations continually upwards: higher stock prices increase market capitalizations, which means that these stocks gain more share in the indexes, which in turn fuels additional inflows to these stocks as millions of investors in passive funds make their regular contributions to their retirement plans.
Ultimately, this phenomenon enhances concentration even more.
This phenomenon is called “bad breadth”.
The firms managing the indexes realize this and are pressed to take corrective measures.
In late July, the Nasdaq 100 index underwent a “special rebalance” to address this issue for just the third time in its history. Beyond doing investors a favor, the firm managing the index wants to avoid being sanctioned by the SEC for exposing investors to an ‘under-diversified’ passive investment fund that is supposed to represent the 100 largest non-financial firms listed on the NASDAQ.
The popularity of indexing – and the marketing messages driving inflows to these investment vehicles - has failed to adequately address the dangers of overconcentration: the reality is that being overly invested in a handful of tech companies increases portfolio risk substantially. These companies are subject to similar industry risks that could create devastating effects in investor portfolios should market conditions change.
Indeed, even casual observers realize that the “big seven” tech titans are all benefiting from the same secular trends: cloud software, microchips, Artificial Intelligence, the Internet of Things, Big Data, robotics, autonomous vehicles, etc.
If we zoom out a bit more, the top twenty stocks in the S&P 500belong to the information technology and communication services sectors. All the other economic sectors – such as energy, discretionary and defensive consumption, real estate, industrials and health care, among others – are all absent.
Thus, it is vital for investors to understand that the major passively managed indexes offer very little diversification at present. In fact, they present serious over-concentration risks.
What Should Investors Do Right Now?
Here are some general recommendations for investors looking to take advantage of the current market environment:
- If you have a multi-asset portfolio, consider increasing your fixed income exposure to your maximum target to take full advantage of the attractive yields offered by high-quality (aka Investment Grade) bonds.
- Incorporate significant portion of bonds that are largely uncorrelated with stocks, such as short-term government and corporate bonds.
- Consider the potential of dividends as a way to offset the potential risks of growth-focused stocks. As explained, growth stocks are very concentrated in the technology sector and have very high price to earnings ratios, which suggests they may be overvalued.
- Finally, don't underestimate the potential of actively managed U.S. stock strategies that are not overly exposed to the handful of technology companies that dominate major indexes. While they may underperform momentum strategies, they could offer better diversification and exposure to the growth of economic sectors that are under-represented in the major passively managed index funds.
All in all, the current market environment is rife with opportunities. How you react depends on your long-term plan, tactical approach, risk tolerance and individual preferences.
As always, we remain at your disposal to discuss your financial goals.
Please reach out at any time to schedule an appropriate time to review your portfolio with your dedicated advisor.
All the best,
Your Wela Financial Advisory Team
*Brent Forrest & Associates, LLC dba Wela Financial Advisory( Wela) is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
Wela may discuss and display, charts, graphs, formulas which are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graph offer limited information and should not be used on their own to make investment decisions.
