Many investors overlook a critical distinction: Allocation versus diversification. The two aren’t the same. Broad allocation is what many mutual funds do by owning the securities of hundreds of issuers. Allocation addresses the “don’t put all your eggs in one basket” adage.
But even broad allocation can fail to deliver diversification.
Diversification requires a more selective approach to allocation. It comes about when portfolio asset returns don’t always change in the same direction at the same time – that is, when they’re non-correlated.
Diversification helps reduce volatility and simultaneously address the “eggs” risk. We believe diversification is superior to broad allocation.
Now is the Time for Investors to Get the Distinction Right
Stock market price volatility recently set new records. Economic growth has slowed in some regions of the world. Economic events send useful signals. This condition is global. It’s not enough to broadly allocate assets because correlations between world regions and asset classes are too high. And during stock market sell-offs, correlations rise even more.[i]
We want you to avoid feeling like you’re falling into the ring of fire – like you’re caught in a downward spiraling market where only the abyss awaits. Part of the solution uses the “three Bs” to help investors understand how economic fundamentals affect market changes: Big macro, Bond yields, and Buffett (as in Warren, the Oracle of Omaha).[ii]
The stock market is not an indicator of future economic performance. Rather, economic growth influences stock prices. Big macro means macroeconomic developments can help investors make better sense of market changes.
And it is not just about what’s happening within our borders. In 2018, eight economies slipped into economic contractions. They include emerging economies like Argentina and heavy weights Japan and Germany. Contagion threatens the U.S. economy.[iii] In this globalized economy, when Asia catches a cold, the Americas cough and Europe sneezes.
Bond yields reveal more than just the current cost of debt. The yield curve slope is one of the most interesting and useful stories bond yields tell, and now the story grows menacing. The day before “Ring of Fire” aired,[iv]the 2-year Treasury yield equaled 2.67 percent and the 5-year equaled 2.65%.
That’s not the way it’s supposed to be. Longer maturities should have higher yields. Inversions predict recessions.
And notice this: The Federal Reserve (the Fed) started increasing its federal funds rate target more aggressively in December 2016. In each of seven times since then, the Fed increased its target by 25 basis points. And since then, the 2-year Treasury yield increased 140 basis points while the 5-year yield only increased 63 basis points. The 10-year only increased 19 basis points.[v]
If the Fed continues to force short-term interest rates higher, we expect the yield curve will upend. Unfortunately, we don’t think the Fed always gets it right.
This brings to mind what we call the “Cycle of Stupidity.”
The cycle starts with low interest rates, like what Quantitative Easing created after 2008. The result is reckless corporate borrowing. Stocks rise beyond defensible prices, the economy overheats, and then the Fed tries to cool the pace by increasing interest rates. The Fed creates shockwaves. Lenders react by pulling back on the reins. Then layoffs, defaults, bankruptcies, and recession follow. We’re back in crisis mode at this point, so the Fed tries to stimulate the economy by lowering interest rates. And history repeats itself again.
Take a minute to request a copy of the “Cycle of Stupidity” by contacting us at firstname.lastname@example.org.
Warren Buffett is widely considered one of the most successful investors of all time. His extraordinary experience, education, and resources enable him to gather, interpret, and act on economic data with unusual proficiency. Some investors suggest following his trades[vi]because they believe more or less exposure to certain sectors can reveal his sentiment. But, perhaps his approach to investing is most instructive. It generally favors solid research, analysis, and discipline.
Putting it All Together
First, it’s best to avoid the “Ring of Fire.” Like almost everything else in life, we are better served by preparing for potential threats before they present themselves. FinancialFortitude.com introduces investors to Preventative Wealth Care®, a proactive program for investing.
In our opinion, preparation requires selective allocation to non-correlated assets (not broad allocation). For accredited investors seeking potentially non-correlated assets, we believe direct participation real estate (DPRE) can serve investors’ interests. Find personalized DPRE support and information at directrealestate.com.
Second, we believe investors should reject the stock market as a guide for the future. Rather, by using Big macro, Bond yields, and Buffet, investors can assess the economy’s prospects. The “Cycle of Stupidity” illustrates the historical pattern we’ve witnessed for many years. Recognizing the “You are Here” point in the cycle can complement the practical utility of the “three Bs.”
[i]Longin, F. Solnik, B. (2001). Extreme correlation of international equity markets. The Journal of Finance, 56(2), 649-676.
[ii]Thanks to Dividend Sensei for his guidance in Sensei, D. (2018, December). Why you should ignore stock prices and focus on these 3 things instead. Seeking Alpha. Retrieved from https://seekingalpha.com/article/4228635-ignore-stock-prices-focus-3-things-instead?source=confirmation_funnel_app_promo. This discussion uses Mr. Sensei’s terms, “Big macro,” “Bond yields,” and “Buffett,” to present information investors can use to interpret the economy and markets.
[iii]Basajian, E. (2018, December). Let’s talk about growth – 8 countries don’t have it. Seeking Alpha.Retrieved from https://seekingalpha.com/article/4227666-talk-growth-8-countries.
[iv]“Ring of Fire” aired 21 December 2018. Get the podcast at https://am1280thepatriot.com/content/all/financial-fortitude-podcasts?apt_credirect=1
[v]The U.S. Treasury publishes daily Treasury yields at https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield. The Federal Reserve’s changes to its target federal funds rate appears at https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield.
[vi]Several sources compile trades by money managers including Warren Buffett, but the original source is SEC.gov. Search instructions are here: https://www.sec.gov/fast-answers/answers-form13fhtm.html.
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