MorningWord 8/27/14: Don’t Get Caught Sitting on a Nest Egg $SPY

by Dan August 27, 2014 9:42 am • Commentary

I want to share an email I got from a close friend who is 70.  He still works as hard as he did at 50 years of age, and has been contemplating his asset allocation with the headlines of the S&P 500 above 2000. The individual, like many of us, has felt the pain of watching equity values drop from very high levels on two other occasions in the last 14 years, and has been patient on both occasions to get back to even (or better) without making poor decisions at or near the tops (buying into the euphoria) or poor decisions at or near the bottoms (panic selling).  I would suspect that his actions are not the norm, but if S&P 500 at 2000 is nothing more than a nice round number, it is at least a great opportunity to reflect on what got us here. With the Fed’s low interest rate policy and historic expansion of its balance sheet to over $3 trillion in fixed income assets closer to the end than the beginning, is it time to re-assess the risk/reward of our investment portfolios?

Here was the email I received after yesterday’s close:

I spoke with a retirement counselor today.  He said that we appear to be adequately funded for retirement, but that maybe we are overly weighted toward stocks, in part because of the market’s gains; we are about 55% equities and 45% in bonds, real estate, etc.  Any ideas?  Is there a formula?  [I know, I know . . . not all stocks are the same and ditto bonds.]  The good news is…..the counselor said that we could move from 55% equities to 38% in 24 hours, with the additional cash going into a guaranteed 3% return account that would not be restricted.  We could move back to equities overnight without penalty.

Any thoughts?

The answer I gave could should be taken with a grain of salt. The counter-argument to this is that there is no end to the rise in equities as Fed policy will remain accommodative for some time, the economy could start to pick up and with such low inflation, stocks are the only game in town.

The other caveat is that each individual’s retirement situation, needs, and goals are going to be different.  I know my friend and his situation quite well, but you should certainly consult with a retirement expert for your own individual needs.

 My response:

On many measures, valuations in the current market in the U.S. are at levels only seen during prior periods of market excess.  Valuations outside of the U.S. are more reasonable, though the push by the central banks of the world to keep interest rates low has made it difficult to find cheap assets anywhere.
As a result, asset prices in the financial world post greater risk than normal.  At this stage of the economic recovery (where unemployment and GDP are), rates should be much higher. FOMC is winding down quantitative easing (bond buying) that started as a disaster prevention mechanism during the financial crisis in 2008, but 5 years and $3 trillion in bonds later, they have created what I feel is a very dangerous situation where the foundation for owning both stocks and bonds is rooted in untested monetary policy.
For those like yourself who have lived through two risk asset implosions where stocks had peak to trough drawdowns of 50% in the last 14 years, I think it makes sense to sell a little of your stocks and bonds every month, adding to your cash pile over time. The stock market is at all time highs, up 200% from the 2009 lows, and it appears that most strategists/pundits are in universal agreement that economically we are in a bit of a “Goldilocks” period with stable economic growth and low rates and inflation aiding the case for central banks to keep rates abnormally low. All of it seems a bit artificial to me, pushing out the next recession but still inflating risk assets.  We seem to have pulled forward future returns, so cash might be a better asset than history suggests.
This is obviously advice for a very specific situation (entering retirement) and I would have no problem advising the friend to go heavier into stocks following a correction. But for now I think the the risk/reward of the market at new highs calls for prudence. After fabulous gains in both stocks and bonds, as result of  unprecedented conditions, capital preservation should outweigh appetite for risk in my opinion.

Oh and one last thing, if you are 70 and don’t think your ticker could handle another 50% peak to trough drop at some point in the next few years, then you may also want to ask your cardiologist his advise not just financial counselor and friendly skeptical market pundit.