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(Corrects firm name of Clinton Investment Management.)
“Facing the Portfolio Allocation Decision?” That’s the title of a note recently penned by Jim Paulsen, chief investment strategist of $330 billion-large Wells Capital Management.
It’s a perceptive piece. With so much talk of upcoming gastritis in the fixed-income market, the trillion-dollar topic on the lips of every broker—both graybeard and greenhorn—is whether, how, and when to shift funds. Clients are calling, seeing a stock market they’ve largely shunned for five years somehow flirt with a new record. (I don’t know, am I missing out?) With their fee meter running and perhaps never so scrutinized, those brokers don’t want to get all told-you-so’d, as they did in 2008 and then again in the Flash Crash and euro correction of 2011. They also know they can’t just hide in cash, an asset that gets them no skim, no commission, nothing toward their production quotas in Wall Street’s ongoing shakeout of financial advisers.
All this as Vanguard, the pathological cheapskate sucking all the fun out of Wall Street’s fee machine, has this Hubba Bubba motif atop its home page that asks: “Bond bubble/bond cliff: How should you respond?”
Broking, long a fine extractive industry, was not supposed to be so complicated. At its most basic level, adherence to a 60/40 split in equities and bonds—with more in the latter as clients get older—was enough to free up the adviser to go out and collect assets, ideally over expense account dinners at Morton’s Steakhouse. Such diversification, after all, bought you zig when one side is zagging in the wrong direction. In 2008, for example, when stocks were felled by 37 percent, 10-year Treasurys, that international redoubt of safety, gained 20 percent.
But never has the bond market enjoyed this kind of three decades, which started with huge double-digit interest rates and was capped off by the Bernanke Federal Reserve pushing yields down to seemingly impossible lows. The upshot: Over that stretch, stock and bond returns have been nearly identical, regardless of the allocation between the two asset classes. That’s taught a complacency toward the reality that things can also fall apart in bonds .
“With a current 10-year Treasury yield of only about 2 percent,” writes Paulsen, “investors can no longer depend, as they have for decades, on a persistent decline in bond yields [which boosts the price of their bonds]. Who knows what the new face of the bond market will be? … What is clear, however, is that its long-standing character is about to undergo change and its relationship to stock investments will also likely be altered.”
But, thinks the broker, clients still want (demand) yield. So when there’s an up-creep in interest rates, like that which started the year, do you plow back in and hope for the best? Or would such a decision ensnare clients in a bond bear, hitting them with losses they never thought they were in the market for? It’s like the game of chicken meets portfolio allocation.
“From many brokers’ perspective, there’s a tendency to look at bonds as trades, not a placeholder for stability,” says Andrew Clinton, president of Clinton Investment Management, which oversees $260 million out of Stamford, Conn. “But for the clients we serve, it’s about risk tolerance, especially as they get older—about ‘I need x amount of dollars to sustain me.’” He says many have persuaded themselves that the stock market, what with its perennial tales of insider trading and other Wall Street malfeasance, is “not a fair playing field.”
The question now is how much that dogma holds if:
1) The bond market turns for the worse, and/or…
2) The four-year bull stock market keeps hoofing up, and/or…
2b) Equities again burn those who dare wade in, after the Standard & Poor’s 500-stock index has gained more than 100 percent, sans correction for quite some time now.
“Compared to the last 30 years,” says Paulsen, “the next investment era may produce similar equity returns but far lower bond returns. Expect the added diversification provided by bonds to diminish substantially relative to the smoothing impact bonds have provided.”
Investors, he advises, should prepare for a much steeper trade-off between risk and reward, and “question whether current conventional asset allocation parameters, born out of the culture of the last 30 years, are still appropriate.”
As for doing nothing, there’s a growing realization that—paraphrasing Bush 41—this passivity will not stand.