Economy

How to Ask the Right Questions

By Michael Coolbaugh  |  November 7, 2019

Bernard Baruch said, “Something that everyone knows isn’t worth anything.”

I absolutely love this quote. A lot of smart people invoke it. And they always assume you know what they’re talking about. This dynamic itself reveals what Baruch was getting at.

Here’s the thing: When we talk “markets” out in the world, people often assume we mean the Dow Jones Industrial Average, the S&P 500 Index, and/or the Nasdaq Composite.

And why wouldn’t that be so? After all, those are just about the only data nightly news programs report to fill their “business” segments. And, of course, stories about “euphoria” or “panic” will lead the broadcasts when they happen, as big gains and big losses for those indexes make for great graphics.

We’re amenable to those kinds of “heuristics,” or shortcuts – and then they’re seared into our brains.

But, sometimes, we have to cut through all of that training. Because there’s a potential risk lurking that dwarfs the 2008 Global Financial Crisis or the 2000 Dot-Com Bubble. And it has absolutely nothing to do with the stock market…

Before the GFC, it was considered fact that, in order to secure your financial future, you needed to buy a house. Not only would buying a house give you equity. As the story was told, home prices would also always go up over time.

Part of this “belief” was a matter of demographics – anyone born after 1940 had only witnessed rising home prices over long periods of time.

But the other part of this was the blind acceptance of conventional wisdom despite the lack of true empirical evidence.

So, what is it today that everyone knows to be “fact” but that, in reality, poses grave potential risk to your wealth? Well…

The Bedrock of Every Portfolio…

I earned my first real experience in the world of finance during my undergraduate years, interning at several wealth management firms during academic breaks.

Regardless of title, from intern to middle manager to CEO, there was one rule of thumb; I’m sure many of you have heard it: “The percentage of your investments allocated to fixed income should match your age.”

Seems pretty simple and rooted in logic…

It provides a steady stream of income and – here’s the kicker – it diversifies your portfolio.

When Stock Prices Fall, Bond Prices Rise…

We’re then shown some form of this chart, which demonstrates how a mixture of stocks and bonds will not only improve returns but greatly reduce your risk as well…

These types of charts, prepared by purported experts, do well to establish conventional wisdom.

At the same time, as was the case with home prices, demographics also support this belief.

Anyone – individual or professional – who’s been investing since the early 1980s has only witnessed falling interest rates and rising bond prices over long periods of time. (Interest rates and bond prices move inversely to each other).

All sounds great, right?

But what happens when something we accept as “fact” turns out to be slightly less than true?

What happens if an analysis similar to one performed on home prices dating back to the late 1800s demonstrates that stocks and bonds are not always inversely correlated?

In fact, analysis from Artemis Capital Management demonstrates that stocks and bonds have been “highly correlated” more often than they’ve been “anti-correlated.” And that undermines the premise upon which every single financial plan and institutional portfolio is built.

It means that vast sums of capital around the world are predicated on safe bonds protecting a portfolio of risky stocks.

Masters of the Universe

You see, it’s a well-known fact that interest rates are low. It’s equally known that central banks around the world are dedicated to keeping them there for a very long time. The argument is low interest rates make equities more attractive.

As we can see below, the difference between the S&P 500 dividend yield and the yield on the 10-year U.S. Treasury note is near extreme levels that have preceded strong moves higher for equities.

And the same can be said for Europe as well…

What If?

But what if we’re looking at all of this the wrong way?

What if these modern-day “Masters of the Universe” can’t maintain control?

What if something that’s guaranteed to always go up over time no longer follows these imaginary laws?

What if a shock originates, not from risky stocks, but from safe bonds?

Maybe – just maybe – we might want to consider that interest rates below the rate of inflation aren’t worth the risk…

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