This month’s letter argues that rising rates are fundamentally changing investing and asset allocation. Our basic premise is that interest rates are artificially low and will continue to rise, which, in turn, will hurt the performance of equities and bonds. Traditional 60% equities and 40% bond asset allocations will need to change to include alternatives like commodities, private equity, venture capital to boost their performance. The decision to overweight alternatives asset classes in the allocations of marquis university endowments like Yale’s and Harvard’s was key to their significant outperform over the last three decades.
This may be the most compelling time in the last 40 years to add alternatives asset classes—commodities in particular—to your investment portfolios. (Yes, this period was the 1970s when inflation and spiking oil, silver and soybeans prices dominated the news….)
- Interest rates are rising and have recovered less than half their yield in 2007 before central banks began their artificial stimulus.
- Rising interest rates will hurt stocks and bonds performance.
- The end of the 34-year bond bull market implies a market correction measured in years.
- Rising interest rates will push commodity prices higher.
A Brief History of Interest Rates:
The chart below shows where interest rates were before the onset of the 2008 Financial Crisis:
- 10-year US Treasury bonds yield about 2.85%, down from 5.26% but up from 1.37%. This suggests yields will likely rise another 2-2 ½% before returning to the 5% level.
- Fed Funds yield about 1.7%, down from 5.41% but up from 0.04%. This suggests Fed Funds will likely rise another 3.7% before this tightening cycle is over.
A picture is worth a thousand words. The chart below reflects all interest rates since 2007. It shows interest rates’ significant decline in yield during the Financial Crisis and their slow but steady reversal commencing in 2013 with the Fed’s “taper” of Quantitative Easing. Our confidence in the prospect of higher rates is based more on central bank mechanics than economics. In other words, global central banks’ need to return to a normal non-accommodative stance and unwind their $15 trillion in asset purchases–since 2008–is a more powerful force than normal economic forces—like inflation—on interest rates.
Rising Interest Rates will Hurt Stocks:
Financial analysts will say “rising interest rates will reduce the present value of future cash flows and hurt equity prices.” While those analysts are absolutely correct in what they state, the average investor living on a budget will reach the same conclusion by saying asking “where can I get a higher yield on my money?”
The chart below shows the yield of three-month Treasury bill compared to the S&P 500. In 2007, the yield on three-month Treasury bill was double what the S&P 500 yielded. The global central banks’ financial engineering forced investors out of safe short-term investments–like Treasury bills and money markets– and into riskier assets like the S&P 500, longer maturity bonds and real estate.
We believe that as rates continue to rise, stocks will need to offer a higher yield to remain competitive. This means that stocks will be under pressure over the coming years. We first saw this pressure on February 5th, when the Dow Jones Industrial Average dropped nearly 1500 points intraday. We saw rising interest rate’s impact this week when Italy’s bond market spiked higher and the Dow Jones Industrial Average dropped 500 points intraday.
A Long-term Perspective on Stocks and Bonds:
Now that we have established that the Fed has taken the “punch bowl away.” Let’s look at interest rates over a longer-term perspective.
The chart below shows the 10-year US Treasury Yield and Shiller’s “Cyclically Adjusted PE Ratio” (CAPE) since 1880. In 1981, 10-year US Treasury yields peaked near 15% when the S&P 500 index was at 129.6. You can also see the 10-year US Treasury yield (red dotted line) rising from 1940 to 1981. From 1981 to 2013 interest rates declined and drove record bull markets in stocks, bonds, and real estate. We think that this rising rate cycle is secular–not cyclical–and will be a multi-year phenomenon.
Trough Equity and Bond Prices in 1981:
The table below shows the S&P 500 price and 10-year US Treasury yield of 14.94% in August of 1981. One can quickly calculate that in August of 1981, the dividend yield on the S&P 500 was 5%, the price-earnings (PE) ratio was 8.54 and the 10-year average PE (CAPE or Cyclically Adjusted PE Ratio) was 8.4! That was at the bottom of the bear market for stocks and bonds.
Near Peak Equity and Bond Prices in 2018:
By comparison, the data below shows the current metrics for the S&P 500 and 10-year US Treasury. Today the 10-year US Treasury yields about 2.85%. The current dividend yield for the S&P 500 is 1.85%, the PE ratio is 24.6, and the 10-year PE or CAPE is 31.27 almost equal the 1929 CAPE! We don’t dispute the recovery of the US economy and its potential to strengthen. Unfortunately, the level of market risk underreported and most investors are oblivious to the potential risks in the market. Today’s stock market valuation is so expensive, it is only exceeded by the valuations achieved during the Tech Boom of 2000–arguably the greatest stock market bubble ever.
Rising 10-Year Yields Cause Higher Commodity Prices:
History tells us that interest rates and commodity prices rise at the same time. There is a mathematical reason for rising interest rates to lift commodity prices. Bloomberg columnist Shelley Goldberg[note]https://www.bloomberg.com/view/articles/2018-02-09/rising-10-year-yields-point-to-higher-commodity-prices[/note] wrote:
“Interest rates are one of three elements that help determine the intrinsic price of a commodity. The other two are storage costs and insurance because there’s a “cost of carry” to both stores and insure commodities. These three factors determine the price of a commodity at each point along its forward (physical) curve or futures (financial) curve.” Higher interest rates raise the cost of carry so if you are buying commodities, higher rates translate to higher commodity prices. Goldberg continued “Should long-term rates rise enough that inflation becomes a concern, investors will turn to commodities like gold and crude oil as havens. In addition, governments of heavy commodity-importing nations may hoard inventory as they did in 2008, severely driving up prices of commodities such as wheat and copper. And portfolio managers will turn to commodities as a way to diversify as they sell equities, which tend to suffer in high-interest rate environments as borrowing costs for businesses rise.”
The serious risk Behavioral Economists and Income Growth Advisors fear is that a negative feedback loop can occur where rising commodity prices, lift inflation, which in turn drives higher interest rates, which accelerate even higher commodity prices. If this happens, investors who are shifting stock and bond exposure to alternative asset class exposure—like commodities–can profoundly change their investment return prospects.
So How Do I Adjust for Rising Rates?
To help manage this changing investment environment, we are introducing three new investment profile strategies:
- Rising Rate Portfolio Profile: This profile is designed to hold value and produce income in a rising interest rate environment.
- Commodity Portfolio Profile: This portfolio strategy which will own commodity sensitive stocks like Deere & Company (DE), Caterpillar Inc (CA), BHP Billiton Limited (BHP), Rio into PLC (RIO) and commodity ETFs.
- Ivy[note]The Ivy Portfolio was highlighted in Mebane Faber’s excellent book: The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.[/note] League Endowment Strategy: This strategy utilizes a broad-based ETF strategy and invests using the principles of the immensely successful Yale and Harvard endowments. The investment objectives of these endowments are similar to that of the typical retirement-oriented investor. Our Ivy League Endowment Strategy seeks to generate income and conservatively grow its capital since retired individuals and endowments generally have limited earnings capacity to recover from losses of capital.
The Ivy3 Portfolio below shows that the current allocation strategy is 40% cash having exited the bond allocation and the real estate allocation.
The current IVY3 portfolio Model developed by Cambria shows both bonds and Real Estate Investment Trusts REITs have been removed from their portfolio. Not only does the momentum signal suggest being out of bonds and real estate, the model allocates 20% to a commodity ETF which is consistent with our risk management allocation guidance.
One way to add to commodities is to invest in energy. Energy has been in a bear market since oil peaked in July 2014. Oil bottomed in 2016 and now energy companies have low stock prices and recovering earnings.
The chart below shows energy stocks had the highest year over year earnings growth of the ten S&P sectors.
MLPs as a Commodity Proxy
Master Limited Partnerships are a commodity proxy due to their correlation with oil. The chart below shows our MLP SMA strategy. Historically, we have outperformed the S&P 500 by a healthy measure as well as beating the Alerian MLP Index and Alerian ETF.
There is a good valuation case to be made for MLPs too. David McColl writes[note]Dividend Trap or Compelling Total Return Opportunities? Fort Washington Investment Advisors, Inc. April 25th, 2018 | By David McColl[/note]:
“Earning Power Value (EPV)”
EPV represents the value of a business based on normalized current cash flows, assuming no growth of future cash flows. EPV indicates the market is pricing in close to no growth, while we look for EBITDA growth to be in the high 20%’s in 2018 and low 20%’s in 2019.
- An EPV of 1.0 indicates the market is pricing in no growth.
- The Alerian MLP Index EPV bottomed at 0.8 in the Great Financial Crisis (GFC) (2007-08) and 1.1 in early 2016 ($20s WTI).
- EPV peaked near 2.4 in 3Q 2014 ($90s WTI). The long-term historical median is roughly 1.7.
- At the current level of 1.1, we view MLPs as very undervalued with almost no growth priced-in.
Private Equity and Venture Capital:
Two alternative asset classes, which have enjoyed exceptional historic returns in and outside of Yale and Harvard’s Endowments, are private equity and venture capital. Due to the lack of liquidity, these longer term and exclusive investments often provide high noncorrelated returns and are worthy of serious consideration, especially when the forecasted returns for stocks and bonds are muted. Unfortunately, these investments are not publicly traded, so their inclusion in typical individual portfolios is limited. However, we will be reaching out to private equity and venture capital companies in the coming months as this appears to be a very attractive asset in which to invest.
Due to the recovery in energy and our expertise in energy research, we will be contacting energy private equity and energy private equity funds as they seem to be especially well positioned for noncorrelated outperformance. We welcome any thoughts or insights as we research energy venture capital and private equity.
We believe that we are heading into a new era in investing. Traditional 60% equity 40% bond asset allocations, a historic cornerstone of retirement and endowment investing, will likely underperform as rates continue to rise and stocks and bond revert. Those who prudently adjust for the rising interest rate environment and allocate to alternatives assets like commodities, private equity and venture capital should significantly outperform their peers. Harvard’s and Yale’s endowments allocated to alternative assets over the last 30 years and led to significant outperformance. Now that interest rates are rising as global central banks reverse their unprecedented accommodation including $15 trillion in asset purchases, this is a time for action.
We welcome your questions and input.
Tyson Halsey, CFA