By: Andrew J. Willms
President and CEO of The Milwaukee Company
In last week’s newsletter article, (which you can find HERE) I discussed why I don’t put a great deal of faith in year-end stock market forecasts. This week, I would like to share my thoughts about what might happen, and what you can do to prepare for these possibilities.
Interest Rates Could Rise.
Federal Reserve Chairman Jerome Powell famously said he’s “not even thinking about thinking about” raising interest rates. Nonetheless, it’s possible that the Fed may not be able to keep the lid on rates in 2021.
The Fed’s primary tool for keeping yields low has been a willingness to buy bonds irrespective of the return it receives on its investment. By doing so, the Fed has created demand for low interest-rate bonds that individual and institutional investors may be unwilling to buy because the return is not sufficient.
Of course, the Federal Reserve is charged with the responsibility of keeping inflation in check (and unemployment low). It may have to reduce its bond purchases to fulfill its inflation mission. If so, the demand for bonds will fall, which in turn would cause rates to rise.
A Stock Market Bubble Could Burst.
The U.S. tech giants have been on a tear for a year now, and equity valuations generally are at levels exceeded only by the ’90s boom years. The best-known measure of market value — the “cyclically adjusted price/earnings ratio” of Yale’s Nobel laureate, Robert Shiller – has soared to heights not seen since the dot-com bubble of 1999-2000, and we all know how that turned out. High valuations do not in and of themselves equate to a bubble, but you can’t have one without the other.
Then again, there are plenty of reasons to believe that the stock market has more room to run in 2021. At current interest rates, bonds pose little competition, the Fed and Congress seem willing to continue to support the stock market via stimulus and deficit spending, and much of the equity market’s recent gains have been focused in the tech sector, for which the future looks bright.
But as a thought experiment, let’s assume that the heights the stock market has reached are not justified. What may cause the bubble to burst in 2021? Generally speaking, stock market bubbles burst for one of two reasons. The first is the Fed rolls back its efforts to stimulate the economy and starts rolling out a hawkish monetary policy. If the Federal Reserve can be taken at its word, that’s not likely to happen anytime soon.
The second is the economy takes an unexpected turn for the worse. In that regard, there have been a couple of canaries singing in the coal mind as of late. For one, U.S. retail sales dropped by more than forecast in November and the prior month was revised to a decline -- signs that the economic recovery could be slowing. A second warning sign came in the form of the Labor Department’s announcement this past Thursday that initial jobless claims totaled 885,000 last week, which is their highest level since early September.
Novice Investors Could Panic.
It’s easier than ever to invest in the stock market. Trading commissions are at an all-time low, trading apps like Robinhood and Tastyworks have made it a breeze to buy and sell stocks, and the Covid pandemic has left millions of Americans at home with time on their hands. Further, fractional shares are now available, which have been a boon for novice traders with tiny portfolios who want to invest in pricey stocks like Tesla.
This combination has led to a large group of inexperienced investors who collectively have the ability to exert a great deal of influence on the stock market. Will these rookie investors bail from stocks at the first sign of trouble? If so, equities could be in store for a setback in 2021.
Preparations to Consider.
Ways to hedge against falling interest rates include avoiding longer-term bonds and investing in “floaters” – bonds and other debt instruments that adjust their interest rates based on changes to the London Inter-bank Offer Rate (LIBOR), an international reference rate for various financial instruments.
Another precaution to consider is to rotate away from interest-rate-sensitive perpetual maturity-date bond funds (which have no maturity date and therefore cannot be redeemed for a set amount) to defined-maturity-date bond funds (which do have a specified maturity date). As a result, investors in defined-maturity-date bond funds can be more confident that they will be able to earn a return and recover their investment even if rates move higher.
There is no shortage of ways the hedge stock-market risk. One of the easiest is to set a cap on how much of your portfolio you want to hold in stocks, and to rebalance the portfolio by selling stocks if the cap is exceeded.
A second approach is to allocate a share of your portfolio to investments that hold up well when interest rates rise or stock prices fall. Examples might include floating-rate and inflation-protected bonds, utility stocks, precious metals, and real estate investment trusts (REITs).
A third is to invest in stock-market option contracts that will increase in value if stock prices fall within a specific time frame – otherwise the options could end up worthless. While stock options can be a very effective way to protect against a bear market, they can be risky for the uninitiated.
In sum, I do not claim to know whether interest rates will rise or stock prices will fall next year. But I do think (i) both outcomes have a realistic chance of happening, (ii) reactive investors tend to fail while proactive investors tend to succeed, and (iii) the difference between being reactive and being proactive is being prepared.
Thank you for reading,
Andrew J. Willms