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Observations on the Market

No. 362: If Not Plan A Then……B, C, D, or E?

Written by Greg Denewiler, CFA

There is usually always a plan B. Something else to do if plan A doesn’t look so good. For investors that means there is almost always something to do that may offer some value proposition. An example of this would be July of 2009. The stock market had started to recover from the previous few year’s 50% collapse. If you were nervous and did not feel comfortable investing in the stock market, you could buy a 10-year treasury note and earn 3.3%. Not great, but on $1 million you would at least have $33,000 plus any social security. You are not flying to Europe every month, but at least you will survive … (whatever that means). Twelve years ago, $33,000 went farther than it does today. The point of this exercise is to consider what your plan B was before the recession of 2008- 2009. In July of 2008 treasury notes would earn you $38,000 of interest. It won’t get you rich, but it is an option. Considering that inflation was about 2.5%, at least your purchasing power stayed even. Today, if you are unsure of what to do, $1 million in treasury notes is not your plan B unless you are willing to live on food stamps and your $12,600 per year (the current 1.26% treasury rate). Is there a plan C, D, or E?

All the rules seemed to have changed. Let’s assume you were correct in thinking inflation was about to spike up to it’s current 4% or more. So you bought gold in January, the historical inflation hedge. Gold was at $1,940 per ounce at the beginning of the year. Today it is at $1,790, not exactly an inflation hedge so plan C didn’t work. Plan B was to buy 10-year Treasury bonds at 0.9%. Not only did your bonds decline in value wiping out five years of interest due to higher interest rates, but your purchasing power is in a steep decline (another form of losing money). Maybe you decided to buy a rental property, let’s call this plan D. Hopefully your tenet still has a job because if they stop paying rent you can’t force them to move out based on current restrictions. There is no easy answer here, but if someone is six months behind on rent, their ability to ever catch up is probably slim. Even if they are current on their rent, with real estate prices at their current highs, you might be lucky to earn 5% on a rental house. Plan E would be to buy lower-quality bonds that will earn you 4% or more. High yield bonds now have equity-like risk built into them without the equity-like returns going forward. Tread lightly with plan E; high-yield bonds can lose 30% without much effort.

You might have been lucky enough to buy oil at the beginning of the year at $47 per barrel. It is now $67, a 40% return. However, most investors don’t want 1,000 barrels of oil in their backyard, so you are forced to stick with something like Chevron or Exxon. Chevron is up 18% year to date, but it is hard to find a more unpopular investment than oil right now (that might be a hint), which we will call plan F. Almost all commodity prices are up this year, and it has driven inflation up to levels we haven’t seen in a very long time. The Federal Reserve thinks it is transitory. There are comments across the board as to whether it is or isn’t. One big problem is that if inflation is here to stay for a while, it implies a completely different investment approach than if it isn’t. Housing prices, the stock market, and almost every other asset you can think of (except gold) are up based on very low-interest rates. With higher interest rates, what happens to all our options?

The 10-year Treasury Note was plan B. Just to keep it simple, if inflation stays above 2%, you lose money for 10 years. Plan C is gold. Gold just hasn’t been a good hedge the last several years, so it is anybody’s guess if it works in the future. Keep in mind it pays you nothing while you wait. Interest rates are a big factor in how real estate gets valued. If you want a higher return, then you must pay less for the rental payment you will receive. With rents so high (at least in Denver), it seems like a significant challenge to be able to raise rents much in the next several years. Plan D could leave you with a decline in real estate prices and very little rent increases in the near term. There is one big problem with high yield bonds or plan E. If the economy slows, which it always does, then investors will demand a higher return for the risk that their bonds may default. Historically, default rates are above 10%. Your interest checks don’t grow, and you receive fewer of them. That leaves us with plan A.

If you own a stock that pays you 2.5% and they grow that by 6% per year, which is the market average for the last 100 years, you will have 80% more income at the end of a decade. These stocks will go down just like the rest of the market. However, you will have accumulated at least 30% more in income over the next decade. It is this growing income stream that will bail you out in a challenging economy. None of the other plans seem to offer the same potential income growth as plan A; the growing dividend

 

Observations on the Market No. 362 – Published Aug, 2021

About the Author
Greg Denewiler, CFA
Owner & Chief Investment Advisor at Denewiler Capital Management