Since we are currently experiencing the second longest bull market in history, some investors are worried we are nearing the end of our hot streak and therefore should move out of stocks. I don’t recommend moving out of stocks, but I do recommend a portfolio pit stop, which is a fun way of saying stopping to reassess your current allocation. In this pit stop you can make sure that your current allocation continues to suit your risk tolerance and long-term investment goals since markets have moved up significantly.
It might seem like a review might not be necessary, seeing how neglect has actually benefited portfolios in the recent past. The problem with this is the bull market makes everyone look like their strategy is the right one. You want to make sure your allocation is right in “good times” and also right when we experience a correction.
Not rebalancing your current allocation can make a significant impact on your portfolio over time. For example, let’s say you started your portfolio five years ago with 40% U.S. stocks, 20% international equities, and 40% in core bonds, and haven’t touched it since. Since then, U.S. equities are gaining more than expected, foreign investments are lagging, and bonds are having modest returns, so your portfolio would have shifted from 40-20-40 to 52-19-29 allocation. It might not seem like a huge shift, but you now have a 70% stock and 30% bond portfolio, rather than the more conservative 60/40 you had set up. You are also five years older now and closer to retirement, so that might not be the right allocation according to your risk tolerance.
The allocation between stocks and bonds is not the only allocation that shifts. Really any allocation between assets with differing returns will shift over time. In my opinion, now is the time to take some of the profits from your U.S. holdings and add to your less expensive international stocks. As mentioned earlier, foreign stocks have lagged over the past several years, which is why I believe that now is a good time to consider increasing the weighting of foreign stocks in your portfolio. Having international stocks does not always reduce your risk, but it’s still helpful because global markets tend to move with the stock sectors that dominate their economies. Also, 70% of the stocks trade outside the U.S., so you don’t want to limit your opportunity.
Unfortunately, rebalancing can come with tax consequences depending on the type of account. If you’re rebalancing inside of a tax-sheltered 401(k) or IRA, there’s no tax consequences to hassle with. If you’re selling shares in a regular, taxable account, things can get a little trickier. If the investment has been owned for at least a year, you have to pay the long-term capital gains tax typically of about 15%. However, it is possible to get around the tax bill by donating appreciated shares of stock to a charity. When you donate an appreciated asset to charity, you owe no capital gains tax and also get to claim the donation as a charitable contribution on your itemized tax return.
After determining that the U.S. economy is expanding at a healthy pace, the Federal Reserve recently began raising rates up from what have been historic lows. Since the financial crisis in 2008, the Fed has raised rates three time, resulting in current rates sitting a full percentage point higher. Historically, the Fed has raised interest rates to reign in excessive economic growth and to contain inflation. Currently, the Fed’s goal is to normalize interest rates without negatively impacting growth. The Fed cited steady growth in the U.S. GDP, increasing jobs, very low unemployment, and a minor increase in inflation as reason for a rate hike. There is still uncertainty regarding how often rate changes will occur, but it is safe to say we have entered an environment of higher interest rates.
Changing interest rates can affect the performance of various investment assets. Outside of U.S. treasuries, short-term corporate bond performance improved greatly during periods of rate hikes. In each of the past five rate-hike episodes from 1986 through 2006, an index of one to three-year investment-grade corporate bonds outperformed both classes of U.S. treasury securities. The average return for those rate hike episodes was 3.29% versus 2.41% for 2-year treasuries and -1.87% for 10-year treasuries. Although we can’t predict the future based on the past, I do think it makes sense to be sure you are not in long term government bonds. I often see this in accounts that are being managed by investors themselves in Deferred Compensation plans. Investors don’t realize the interest rate risk they are taking on by having long term government bonds.
With high-yield bonds, the performance increase is even larger than corporate bonds. In every period besides June 1999-May 2000, the Bank of America Merrill Lynch High Yield Index outperformed the Barclays U.S. Aggregate Bond Index. The High Yield Index returned more than the two-year U.S. Treasury note during 3 out of 5 of the periods as well. Combining all five periods, the high-yield index returned an average of 3.84%, compared to 1.21% for the Barclays Aggregate Index and 2.42% for the two-year Treasury Index.
Increases in interest rates also affects the stock market. In the past four out of five rate hike periods, the S&P 500 Index outperformed a conservative investment strategy which invested in two-year Treasury notes. The only time the conservative strategy outperformed the S&P was in 1994 when the Fed raised rates in a surprise move. During the five periods, the S&P averaged a 13.71% return, compared to 2.41% for the two-year strategy. Rising rates are beneficial to bank stocks, since banks rely heavily on income generated by debt. Increases in fixed income and currency-trading revenue should help to boost financial companies higher. Compounded with talk of deregulating portions of the industry, the financial sector looks very healthy. On the other hand, utility stocks and stocks that are related to disposable income tend to not perform very well in high interest environments. In my opinion, investors may also want to look outside of the U.S. for growth opportunities. With global valuations lower than U.S. stocks, it’s likely foreign stocks could provide better return prospects.
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