FWIW #46 Important Portfolio Strategy

It’s been a while since FWIW #45. The primary reason is fatigue from writing about the Fed, its collusion with the political administration and Congress, and its role in creating inflation. I’m going to leave the Fed alone for the time being. Why? Because we’re at a tipping point with the Fed and the investment markets. Let’s start with another investment lesson.

Twice, three and a half years ago and two years ago, I stated as a fact that Donald Trump would never be president again. Two things were wrong with this statement. First, it was a prediction of the future, which I know is senseless and stupid. It’s an example of the truth that even when a person is knowledgeable about the error of trying to predict the future, they can still make the mistake. Investing is like that as well. Wall Street is built on the premise that predicting the future is necessary to make money. That’s not true, and real investors on Wall Street know it. Second, I compounded my stupidity by forgetting a famous saying by one of the Rothschilds: “Buy when blood is running in the streets.” I failed to look at Trump’s history demonstrating his ability to overcome multiple challenges and obstacles to succeed.

The media and investment community are focused on the stock market. The important portfolio investment strategy today is to understand the fixed-income markets. Last September, when the Fed reduced its benchmark fed funds rate by 0.5%, the pundits expected the whole interest rate yield curve to fall, not only because of the rate cut but also because the Fed signaled further cuts were coming. Interestingly, a different signal came from the markets: one year and longer interest rates started going up instead of down. As a matter of fact, the one-year through thirty-year treasury bond maturities are now in a “normal” yield pattern. This means the longer a bond’s maturity, the higher the yield. For more than a decade, this was not the case. Since 2008, the yield curve has been inverted much of the time. The market now appears to be signaling to the Fed that the underlying inflation rate may be stuck at current levels or higher for an extended time. Interest rates may also be reflecting a Trump administration and its professed fiscal policies. Still another major signal is coming from the market in the decoupling of mortgage rates from the ten-year treasury rate. Mortgage rates are moving higher and faster than the treasury rate. Is the market right or wrong?

No one knows, because no one knows how the incoming administration will interact with Congress and what its new policies will prioritize over the next year. Economic signals appear to show the economy is doing fine in the current interest rate environment. For sure, any businessperson with common sense can make money in the current economy. As we have shown in the last two FWIWs, the Fed has maintained a pandemic-era-sized balance sheet and money supply. The balance sheet, while much greater because of Covid-19, is slowly shrinking, but the money supply appears to have started expanding again. It will take time to see how much tension arises between the Trump administration and the Fed. That’s another issue altogether. Don’t try to guess it or listen to the media. Let the markets tell you. What’s important to you is making sure you’re taking advantage of the current fixed-income market.

In the bond market, there are two distinct markets: US treasuries (for those who like to take political risk in large doses, there are other countries’ sovereign bonds) and US corporate bonds. Two categories have been left out: government agencies and private credit bonds/loans. The government agencies are not without risk in a serious financial disaster, and the private credit bonds/loans are only for speculators who understand the documents controlling the debt and the bankruptcy laws.

In developing a fixed income market strategy for the portfolio, a handful of factors are important. Which factor is the most dominant varies depending on the complexity of the markets at the time. The most important factor today is the spread between the yield on the US Treasury notes and bonds and the yield on all other fixed-income securities with the same maturity. Here’s what I mean: If the ten-year treasury is yielding 4.5%, the ten-year government agency is yielding 4.65%, the ten-year A-rated corporate bond is yielding 5%, and the ten-year non-investment-grade corporate bond is yielding 6.5%, the difference in yield for each of the lower credit quality securities is not enough to pay the bond holder for the credit risk they’re taking. The current tight relationship among these securities’ credit qualities indicates there is still excessive money in the investment markets.

Some speculators believe fixed-income securities are not as good of an investment as common stocks or other types of ownership assets. I disagree with them for two very important reasons. First, stocks don’t always gain value or maintain a stable valuation. The period 2001 through 2010 saw the major indices, including dividends, gain less than 1% annually. Take out the dividends, and the benchmarks lost money on average that decade. Fixed-income investments changed very little in price and generated steady cash flow during the same decade. That’s not the key reason for owning some fixed-income securities.

The stock market will go down. Sometimes a lot. It’s not unusual for the market to drop 20% and every six or seven years drop 50%–60%. It’s during these times of illiquidity that the true value of bonds in the portfolio is evident. A stock market that is down dramatically is an opportunity of a decade. It’s the time when quality companies can be purchased for a fair value. It doesn’t make sense to sell a price-depressed stock in order to buy another price-depressed stock. If the portfolio contains bonds, the bonds will be close to, if not above, the price paid for them and will be available for a switch from a fixed-income security (bond or preferred stock) to a potential appreciating security that may pay increasing dividends well into the future (common stock).

During good economic times, the bonds will generate cash flow from interest payments that can be used to supplement portfolio withdrawals or to purchase stocks and bonds. In 19 Rules for Getting Rich and Staying Rich Despite Wall Street, I explained a simple plan for developing a fixed-income portfolio. That strategy will work in any investment and interest rate environment. The essence of the strategy is to have steady cash flow some securities maturing on a regular basis. This way, whatever monetary or fiscal policies the authorities pursue, a portfolio will have funds to reinvest at the prevailing interest rates. Thus, the investor will always have portfolio flexibility and will be able to respond to any and all opportunities or challenges that are presented. Portfolio fixed income securities earn their keep through providing cash flow and tactical opportunities.

It’s been more than twelve years since good tactical fixed-income investing was available as it is now. In FWIW #47, I’ll discuss tactical uses of fixed-income securities to enhance the common stock portion of the portfolio.