We don't get as much snow in East Tennessee as I would like. Seeing everything covered in white and my two Wheaten Terriers bounding, chasing each other through the powder puts a smile on my face. Trying to get out of my subdivision and into the office is another matter. The main roads are usually fine (thank you City of Maryville Roads Department). It's the road at the end of my driveway that becomes impassible until the city brings a plow through. East Tennesseans don't need to prepare for winter like our northern friends do. As a result we typically find ourselves unprepared if a big storm descends on us.
Rates are going up. Probably not by much and not in a hurry, but investors have definitely entered into a new financial era. It's been three years since the Fed started promising to raise rates so we've had plenty of time to prepare. Only a few of my colleagues have actually been through these interest rates cycles first hand. Bond manager, Jeff Gundlach at Doubleline Funds observed that two thirds of portfolio managers have never managed money in a rising rate environment.
Janet Yellen tried to temper expectations for the pace and magnitude of rate increases in her press conference yesterday. She explained that the Fed's path will be guided by new information as it develops. The reality is that investors don't have the Feds deep pockets to rely on as a buyer of last resort anymore. Stocks will sink or swim on more traditional measures - earnings, revenue, sales, expenses, debt etc.
Markets experienced an increase in volatility in the second half of 2015 as the Fed slow-walked the world to their first rate increase in nine years. I expect this elevated level of volatility to become a more familiar characteristic as the Fed struggles to find their footing and normalize rates at some unknown, higher level. Rookie fund managers and investors will have to figure out how to deal with this day-to-day uncertainty. Here are four underrated techniques to provide traction to your portfolio when the roads seem impassible:
- Define your investment goals and attach an accurate time horizon to each goal. When the day to day gyrations freak you out, remind your self that time is your friend. If you don't have time to stay in the market, put your money in savings instead and accept a fixed return with lower risk.
- Make sure you understand the relative risk and reward of ALL of the assets in your portfolio. Risky assets haven't acted like risky assets in the last 5 years but they are starting to. This is normal and especially so as rate increases make business growth more difficult to forecast accurately.
- Once you map out the risk profile of all your holdings, reallocate to reduce volatility if you are prone to short-term bouts of fear. The first goal is to stay in the game until you master your own emotions. The end result is to learn to spot when less experienced investors are acting on their fear and providing you an opportunity to buy cheap.
- Have a plan to buy more if prices decline and relative value comparisons justify it. Since 2011 this strategy hasn't been necessary as constant Fed stimulus kept a lid on volatility and pushed valuations higher and higher. In the next few years, without this stimulus, valuation differences between various industries will likely vary dramatically as these industries react differently to higher rates. Businesses that require more capital to operate and grow will see their costs increase more than ones who need less capital. Businesses that sell higher ticket items like houses and cars will face tough sledding when customers try to finance these purchases at higher rates. The broad market will become less homogenized and valuations will vary more dramatically than in the past.
Storms are unavoidable so weather proof your portfolio now. This is a two step process. First, where needed, adjust your investments to this new interest rate reality with the tips above. Second, re-calibrate your expectations for higher short term volatility so that your emotions wont send you into a ditch. Or, call us to help with the process. After three decades of market experience, we've been here before.