At long last stock market volatility returns due to rising interest rates. We’ve now seen a more than 60% increase in the risk free rate since its 2012 bottom and things are starting to get hairy. I’ve been wrongly waiting for a pull back since the beginning of May so it’s good to finally get some sanity back in the markets again.
Nobody knows whether rates will continue to move higher from current levels. However, it’s good to layout a what if scenario so we can be better positioned.
Rising interest rates do the following:
* Makes mortgages more expensive. The window to refinance at all time lows has passed.
* Makes car loans more expensive. One shouldn’t be borrowing money to buy a depreciating asset anyway, so all is good.
* Increases credit card interest rates to even more egregious levels. Nobody better have revolving credit card debt unless they are a financial masochist.
* Increases student loan interest rates, depending on what type of government subsidies you receive.
* Makes the stock market less attractive given the opportunity cost to own securities has increased. One of the main reasons why I aggressively invested in equities in 2012 was because the S&P 500 dividend yield was greater than the 10-year yield.
* Cools off the housing market as homebuyers are now hit with an increase in prices from a year ago and rising mortgage payments.
* Slows down consumption growth, which is the main driver for GDP growth in the Y = G + I + C + NI equation.
* Theoretically increases your savings rates and CD rates, but banks will move like molasses to adjust so don’t bet on anything great for a while.
* Leveraged buyouts will decrease at the margin due to more expensive debt financing.
* Makes bonds look more attractive given higher yields.
* Strengthens the US Dollar vs a basket of major foreign currencies.
* Makes you reflect on what’s next.
It’s important to realize that a rising interest rate environment often reflects underlying strength in the economy as the demand for money increases. Money demand increases due to better employment levels, higher wages, positive growth expectations and a host of other factors. It’s the short term adjustment, which which can be tricky to maneuver.
TIME FOR A GUT CHECK ON RISK TOLERANCE
Large market drops are a great time to assess whether you are currently comfortable with your net worth allocation. I recommend you sign up for a free online tool like Personal Capital to get a bird’s eye view of your money. If you have 100% of your net worth invested in equities your net worth is down around 2.3% on the June 20, 2013 meltdown alone. A summer of 350 point daily Dow drops will wipe out your entire net worth before Fall. Of course this isn’t going to happen unless you are on margin, but it’s a worthy exercise to think about.
If you can stomach 2%+ declines in your net worth a day then having 100% of your net worth invested in equities is fine as well. I personally can’t tolerate much more than a $25,000 decline in my stock portfolio a day based on my assets and retirement situation which is why I’m hesitant to have more than $1.5 million in equity exposure. Perhaps if my net worth grows over time I’ll get more comfortable, but not now. As a result, I’ve diversified my net worth into real estate and CDs as they at least provide an illusion of stability.
You can’t really tell what your real level of risk tolerance is until AFTER you start losing money. All those folks who think they are Warren Buffet because they’ve never had any significant money invested during a bear market have a fun surprise coming because large corrections are commonplace.
OK, so hopefully everybody has done a top down analysis of their net worth allocation or will do so by the end of this post to decide whether they are comfortable with their existing exposure. If you don’t you could seriously wake one fine day and wonder where the hell are your money went. Let’s see what we should do with our money going forward in case rates continue to rise.
INVESTING IDEAS IN A RISING INTEREST RATE ENVIRONMENT
* More Cash. We are in a time period where bonds are selling off due to fears the Fed will start tapering off its bond buying program. As a result, interest rates are rising. When interest rates rise too fast, equities start selling off as well due to fears of slowing consumption, higher opportunity costs, and all the other reasons discussed above. In other words, we are in this negative cycle loop until we find a happy ground. Relatively speaking, cash becomes that much more valuable as other asset classes decline. It’s good to have a healthy cash hoard to start legging back into equities and bonds once you’ve found your risk tolerance.
* Shorter Term Duration and Floating Rate Funds. To reduce your portfolio’s sensitivity to rising interest rates you want to lower the average duration of your holdings. The Vanguard Short-Term Bond Fund (VCSH) is one such example where if you pull up the chart, you’ll see much more stability. Another idea is to buy a bond fund which has coupon rates which float with the market rate. Luckily, we also have an ETF for such a fund called the iShares Floating Rate Fund (FLOT). Treasury Inflation Protected Securities (TIPS) are another less sexy way to invest.
* Focus On Technology and Health Care. Many studies have analyzed the 13 rising-rate environments over the past 64 years and have found that the tech and health care sectors gained an average of 20% and 13%, respectively during the 12-month period following the first rate hike of each cycle. This compares favorable to an average 6.2% gain in the entire S&P 500. Of course the past is no guarantee of the future, but there is something to be said about history. You can easily buy the PowerShares QQQ (QQQ) and the Vanguard Health Care (VHT) ETFs.
* Reduce Exposure To Banks and Materials. On the flip side of the study, financials and materials only showed a 4% and 3% increase during the same period. The idea is that financials get squeezed a little bit as borrowing costs rise and lending costs don’t rise quick enough. Material stocks are commodities that fall out of favor in a growth environment. Again, what’s very interesting to note is that the S&P 500 did gain 6.2% in a rising interest rate environment because rising interest rates are a reflection of increased demand in the economy.
* Structured Notes That Provide Downside Protection. In How To Invest In The Stock Markets At Record Highs Without Getting Your Face Ripped Off I talk about common index based structured notes everyone with enough capital can invest in. The ones I like to invest in are S&P500 Buffer Notes that commonly provide a 10% downside buffer in exchange for locking up your money over a certain period of time and perhaps giving up some dividend income. These Buffer Notes also provide guaranteed minimum upside if the note closes above the index entry price on closing day.
* More Of What You Know. If the fundamental story of the company you own has not changed, then during the short-term adjust period of rising interest rate volatility you should consider investing more in your existing holdings. In fact, you should run screens like a maniac trying to figure out which stocks or funds look attractive. Try and come up with your own price target entry point based on valuations and variables and leg in. Over the long run, the markets trend up and to the right. It all depends on how long you plan to hold on.
DON’T LOSE FOCUS OF YOUR FINANCIAL GOALS
The most important point is to be congruent with your financial goals. There are a lot of delusional people out there who think just because they’ve made 15% in the stock markets this year they can extrapolate 15% a year for decades. This is way too optimistic. It’s much better to be conservative and have lots of money left over than come up short with much less time on your hands.
It’s important to run different portfolio scenarios to see whether you are on target. I ran my own 401(k) through three different portfolios and I’ve come up with $1.15 million, $2.4 million, and $6.8 million after 30 years. I can now adjust my spending habits accordingly. My goal is to protect the financial nut I’ve built over the past 13 years because it spits out around six figures a year in passive income. Run real numbers so you don’t just randomly guess at your future.
I’m personally legging into the markets as stocks fall because I’ve had 65% of my rollover IRA sitting in cash for the past month. I’m adding to my positions in technology, which is a sector that has historically done well in a rising interest rate environment and a sector that I know. Furthermore, I’m increasing my exposure to bonds such as the Templeton Global Bond Fund given I’ve got less than 3% of my net worth in bonds.
I take the sanguine view that rising rates is a positive reflection of the economy. There will be a tremendous short-term adjustment period as the Fed unwinds their support. But I’m confident investors will get used to the idea of a tapering Fed and corporations will continue to generate year over year profits.
Readers, where are you investing in a rising interest rate environment?