By George W. Karpus
The Daily Record Newswire
Beware! Bonds, especially longer-term bonds, are not the place to invest. The risk of interest rates rising is great, especially in light of our Federal Reserve’s intention to stimulate the economy by buying $500 billion of securities from banks. This action will increase the supply of money by a huge amount and should also cause a significant increase in economic activity.
Looking forward, interest rates (intermediate and long-term) should therefore rise, causing bond values to plummet. Further, the credit quality of our debt will also likely erode.
Inflation will eventually become a problem but not until a few years from now. The Federal Reserve may increase the supply of money by over 50 percent of average GDP over the next couple of years.
Due to these circumstances, it is my belief that bonds with long durations should be drastically reduced in long-term investment portfolios. In fact, the bond market may be experiencing an investment “bubble” similar to the stock market bubble in early 2000.
To review how investors could combat such a situation within their portfolio, let’s review how we advised clients to allocate their assets during early 2000.
In 2000, we were recommending that investors should reduce their allocations to stocks and to significantly increase exposure to bonds. Among other factors, we saw that stock values were three standard deviations above their mean values, while, on the other hand, bonds were very attractive.
Based on the indices’ data for how a typical balanced account performed relative to the various indices for each of the indicated time periods, bonds outperformed U.S. stocks by nearly 7 percent per year and international stocks by over 3.5 percent per year for the decade ending Sept. 30.
As the data indicates, our asset allocation decisions based on our observations and our subsequent outstanding performance in each asset class caused the performance of most of our balanced accounts to be better than each of the indices. Additionally, in comparing our portfolio results with the average balanced mutual fund, an investor would have had 65 percent more money as of the 10-year period ending Sept. 30.
Given my experience and my perceptions about the overall marketplace, it is my belief that, at this time, stocks (both domestic and international) offer a better alternative to longer-term bonds. As I wrote previously, this is the alternate version of what occurred in 2000 where I believed that stocks were overvalued.
In considering where to invest in the coming year, what must also be factored in is that much of the excess valuation in U.S. stocks has been corrected in the last 10 years because stocks have been experiencing a negative total return. Let me explain why I believe this is an important factor that must also be considered.
As Americans cheered the “fall” of the Berlin Wall in 1989, the world turned away from communism toward capitalism. In hindsight, Americans, however, should perhaps have been a bit more careful as to what they wished for. In the midst of this historic event, over the last 20 years capitalism has flourished around the globe at a rapid pace.
To illustrate, in 1990, the United States possessed over 65 percent of the world’s capital, whereas in 2009, the U.S. possesses less than 30 percent of the world’s capital. The valuation of U.S. capital is still higher.
Given the shift of capital, in addition to a shift away from longer-term bonds, I also believe that longer-term, a more significant international equity exposure, especially to areas of the world that have governments with better fiscal discipline, is also clearly necessary for one’s portfolio. Additionally, I also feel that commodities including metals and real estate, should also be included in a well-diversified investment portfolio.
In terms of bonds, longer duration fixed income exposure should be limited to countries with higher interest rates and where governments exercise fiscal discipline that may cause their currency to appreciate vs. the U.S. dollar.
Investors must be careful as to how they invest and who they choose to provide investment and asset allocation advice. Many advisors have been increasing bond allocations and decreasing stock allocations. Most of these advisors had high stock allocations and low bond allocations 10 years ago. They were wrong!
It is my opinion that investors need to significantly decrease bond allocations. I believe bond returns will be below their historical average in the years to come. It is most important to remember that asset allocation accounts for up to 75 percent of an investor’s total return over longer periods of time.
As an investor, it is critical that your advisor or asset manager have these conversations with you about your asset allocation and how your choices in this critical arena can severely affect your investments for years to come.
George W. Karpus is president of Karpus Investment Management in Pittsford, N.Y. and an be reached at (585) 586-4680.
