What If…? Rising Interest Rates and Other Market Worries
March 9, 2009, marked the bottom of the financial crisis, which means our current bull market just celebrated its sixth birthday. Much has changed in the past six years: the S&P has returned over 200%, unemployment fell from 10% to 5%, and average housing prices have recovered to pre-crisis levels. But many investors are hesitant to celebrate for fear that the good times may be coming to an end.
These investors include those on Wall Street, who have been nervously waiting for the Federal Reserve to signal that it may begin raising interest rates. Just days after the current bull market turned six, in fact, investors got a hint that an interest rate increase could happen in the near future. So what happens if interest rates rise? Or worse yet, the markets decide the current bull run is over? In this quarter’s commentary we’ll discuss Truepoint’s approach to such events.
What if rates rise?
Some associate rising interest rates with bad news for bond owners. It’s true that as rates rise, the price of a bond decreases; however, this ignores the fact that the return of a bond depends upon price as well as income. Interest rates may rise and fall causing the price of the bond to fluctuate, but a bond’s interest payments won’t change.
Total return considers both the change in price as well as income received from a bond. The chart below shows that there is rarely a negative total return for bonds in one-year periods (orange line). A negative return is even less likely when you consider rolling three-year periods (blue line). In other words, history would suggest that as long-term investors, we have a good chance of protecting principal.
Total Return for Bonds
Another point to be made about bonds is that their primary purpose in a Truepoint portfolio is to be a source of stability. Because the past six years have been largely positive ones for the stock market, it may be easy to forget the crucial role bonds played during the financial crisis. Not only were bond returns positive during the downturn, but their stability provided “dry powder” for opportunistically rebalancing into stocks.
What if the current bull market ends?
In a previous Viewpoint, Is the U.S. Stock Market Overvalued … and Does it Matter? we wrote about how valuations are not a good way to time markets. In fact, there is no good measure that tells us when the optimal time is to buy or to sell. There is, however, a fool-proof way to ensure that you avoid the long-term investor’s worst nightmare of buying high and selling low. The strategy is easy to explain, but can be extraordinarily difficult to employ in fearful times: It is simply to maintain the originally targeted balance of stocks and bonds in your portfolio whether the market is up or down.
It can be so tempting to react to current events, especially when the news is frightening. But despite some very scary events, the global market has ultimately marched onward and upward. Below is the growth of one dollar (green line) invested in a diverse basket of U.S. and international stocks. In the background are geopolitical events (in blue). When the worst happens, we stay committed to our plan by rebalancing from bonds into stocks – which is the best market timing strategy available to us as investors.
…Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak.”
– Warren Buffett to Berkshire Hathaway shareholders in 1994