Investors have faced an uncommon dilemma during the first four months of the year. For the first time since 1976, both stocks and bonds have declined by more than 10%. Bonds are traditionally viewed as a hedge against periodic pullbacks in stocks. Investors have dumped both stocks and bonds as the Federal Reserve has embarked on a campaign to raise interest rates to subdue inflation, which is at a 40-year high. Rising interest rates lead to increased correlations between stocks and bonds, though it is important to remember that anticipating the magnitude and length of time until a rate rise occurs is difficult. So rather than trying to predict rate increases, we recommend that patient investors should trust diversification over the long-term.
Correlations between stocks and bonds increase when the market expects interest rates to climb. The market starts discounting cash flows at higher rates, thereby decreasing the current value of stocks and bonds. That puts more stress on bonds because interest rates directly affect their yields, which make up a large portion of their value. Longer-maturity bonds are at a significant disadvantage because they are subject to more interest rate risk, and inflation can chip away at the purchasing power of the fixed payments.
A rising rate environment may increase correlations between stocks and bonds, but the relationship has historically been modest. Most importantly, during longer time horizons, including periods of stable or falling rates, the diversification benefits between stocks and bonds significantly improve a portfolio’s risk-adjusted returns.
We recommend that investors first maintain an asset allocation predicated on one’s needs and investment time horizon in this environment. Market timing or changing asset allocation is unproductive. Instead, we advocate for a sound and consistently applied investment strategy to choose investments within each asset class.
Our bond strategy is to invest in high-quality short to intermediate-term issues for stability of principal, cash flow, and diversification. We build a ladder of varying maturities that allows us to reinvest shorter-term bonds that have matured into bonds at higher rates, thereby increasing the portfolio’s overall yield. Utilizing low-risk bonds allows a higher allocation to high quality, lower risk equities for the superior returns they provide. Within equities, our strategy is to invest in financially strong, profitable, growing companies. Our methodology is to build well-diversified portfolios of these companies, purchasing shares of individual companies when they are demonstrably cheap compared to their normal valuation levels and selling when they are rich.
We think that this current environment is likely to follow the pattern of most historical precedents in which the equity market first reacts negatively and then recovers over subsequent quarters. Selling at a time of a temporary pullback locks in losses and negates the benefit of compounding. Therefore, maintaining a long-term focus amid periods of volatility is crucial to maintaining your financial objectives over time.
We will be alert for opportunities to add great companies to the portfolios at attractive prices. Give us a call if you have questions or would like to schedule a portfolio review.