By: Amy Irvine, CFP®, EA, MPAS®, CCFC
I cannot believe we have moved into the 2nd quarter of 2021 already. During the month of March, we have been asked, is now a good time to invest, it seems like the market is at a peak? If it is not about the stock prices being high, then it’s a concern over future interest rates causing a slow down in the economy.
The most recent economic news seems to support a continued improvement, as ADP payrolls have gained traction, we are seeing factory activity strengthening and although the value of the dollar is down from its peak in March of 2020, this is generally positive for global growth (read to the end to see this come full circle).
Remember, stock prices depend on future cash flows expected by investors and the discount rate, not one or the other. Even if the discount rate increases, it could still cause stock prices to rise if it is expected that cash flow will rise.
Our friends over at Dimensional Funds recently provided us with research showing the correlation between monthly US stock returns and changes in interest rates.
“Exhibit 1 shows that while there is a lot of noise in stock returns, there is no clear pattern between yield changes and subsequent stock returns.
For example, in months when the 10-Year Treasury Yield rose, stock returns were as low as -17% and as high as +15%. In months when rates fell, returns raged from -23% to +16%. Given there are many other rates besides the 10-Year Treasury, and that interest rates on different points of the yield curve do not always move in lock step, we also examined the relation on short-term interest rates and found similar results.
A follow-up question many may ask is, “what about the impact of interest rate changes on the size, value, and profitability premiums?” Our research indicates that there is no discernable pattern in the historical data to suggest size, value, and profitability premiums behaved differently in months when interest rates went up vs. when it went down. The patterns—or the lack of clear patterns—were similar when we looked at many different interest rates, including the effective federal funds rate and the 1-, 5-, and 10-year Treasury constant maturity rates.
For investors who have a strong belief in the path interest rates will take in the future, the desire to change their equity investment or exposure to premiums accordingly should be tempered with the notion that even with perfect knowledge of future rate changes, one will not have enough guidance about subsequent returns. Instead, staying invested and avoiding the temptation to make changes based on short-term predictions may increase the likelihood of consistently capturing what the stock market has to offer in any interest rate environment.”
Exhibit 1
Yes, it seems like it is same old boring story, stay diversified. But it seems to work (historically speaking).
I read a great article from Morningstar recently that really dug into the data around this. The article was written by Amy Arnott, CFA, and if you’d like to read the whole thing, here is the link.
She points out that in 2020 when the COVID-19 bear market hit, the overall equity market was down 34.5%, but the basic 60% stocks / 40% core bonds “lost about 13 percentage points less than an equity only portfolio.” The paragraph that I would want most readers to pick out, if you only read one paragraph is, “holding a diversified portfolio helps investors expand the opportunity set and ensure they don’t miss out on areas that can enhance long-term returns. International stocks are a prime example. While they haven't improved returns or reduced risk when added to portfolios focused on U.S. stocks over the past 20 years, they probably won't underperform forever. Currency exposure is another important aspect of international diversification. Now that the U.S. dollar has started showing signs of weakness, international diversification could become increasingly important.”
Why is that such an important paragraph to me? Recall, late last year in our meetings, we explained why we were keeping our equity percentage overall the same but reducing a little in US and increase a bit in international. We still believe this minor adjustment is the right direction for this upcoming year.
Of course, something could change and, as you know, we are not market timers, we strongly believe in building and maintaining diversified portfolios.