While money market and Treasury Bill rates look attractive and deserve an allocation in a diversified portfolio, overweighting them too much and forgoing opportunities elsewhere may result in regret in the not-too-distant future. Recency bias is a powerful force that can cause investors to project recent events and market conditions well into the future and may have grave consequences during what our work suggests is the ninth inning of the current rate hiking cycle.
It’s important to note that we do allocate to short-term Treasuries across our Strategies and believe that cash and cash-like investments probably deserve an overweight in today’s volatile market. However, shifting large allocations to cash without a process or plan to reinvest could have serious consequences and cause investors to miss out on other compelling opportunities. Experience teaches us that large market swings tend to shift back quickly as they revert to the mean.
For example, one reason we hear that investors are parking large allocations in money markets and T-Bills is ongoing concerns about the current economic and market situation. An economic downturn or recession could result in financial market turmoil or even a market crash. While that is true, an economic drawdown of that magnitude would likely cause yields to fall for money market funds and T-Bills as well as longer-term bonds. During bouts of severe economic distress associated with these scenarios, central banks generally cut interest rates quickly to loosen monetary conditions and stabilize economic activity. Along with the likely fall across the yield curve, investors overallocated to money markets and T-Bills would see their interest income decline quickly. Meanwhile, investors in intermediate- and longer-duration fixed income would experience little or no change in their current income while also potentially benefiting from capital appreciation as falling interest rates drive bond prices higher.
We believe that investors with a more diversified allocation across fixed income maturities would be in a much better position than those overly concentrated in shorter-term money markets and T-Bills. To sustain an attractive current income, the only recourse for those with heightened exposure to money markets and T-Bills would be to purchase appreciated longer-term bonds or increase credit risk.
Acknowledging recency bias and looking beyond current conditions to a reasonable forecast for interest rates is critical to investment success. Currently, Fed Funds futures markets are pricing in an approximately 60% probability of interest rate cuts at the Fed’s July 2024 meeting. It’s important to consider that the financial markets are often leading indicators as they attempt to price in future conditions before they happen. So, whereas July of 2024 seems like a distant target, the markets will not wait for retail investors to feel good before the shift begins to take hold.
In addition, the Fed Funds Rate (FFR) is now higher than the yield on the 2-Year Treasury Bond, which tends to lead the FFR. As the graph below illustrates, the close relationship between T-Bills and the FFR suggests that if the FFR falls in the coming months, as the 2-Year Treasury implies, T-Bills and money market rates will likely decline as well. Investors without a plan to identify and shift to higher duration fixed income and attractively valued dividend equities may risk missing that opportunity.
Instead, investors may want to reduce reinvestment risk by locking in some longer-duration bond positions as well as dividend paying stocks. Diversification of income sources may be desirable given the differentiation between how fixed income assets and equity dividends derive their income. For equities, dividend income is dependent on the overall health of the underlying companies whereas for fixed income, income is primarily based on the level of the risk-free rate plus a spread to account for risks associated with the bonds. Reinvestment risks are one key fixed income risk to be aware of when comparing differing durations of fixed income assets as well as equity income solutions.
Additionally, while the income stream from fixed income holdings may remain consistent even while money market and T-Bill rates decline, dividend income from high quality companies will likely increase over time. Increasing dividend income can help offset the eroding effects of inflation.
This year’s narrow equity market gains have left dividend paying stocks trading at discounts relative to their own histories and trading at steep discounts relative to the narrow group of equities that has led this year’s market appreciation. In fact, many of these dividend stocks are down year-to-date while their earnings have increased. As the following graph suggests, the S&P 500 Index is currently trading at a premium relative to its price-to-earnings valuation over the last 10 years. Meanwhile, the dividend Index is trading at an 11% discount.
In summary, while the appeal of high current money market rates is obvious, the risks may be less so. Investors should consider the risks they assume when putting too much of their assets into one place. Meanwhile, diversified intermediate- and longer-duration high quality fixed income deserve some attention as they offer compelling income and potential capital appreciation opportunities. Finally, dividend income from high quality equities is more attractive than it has been in some time so investors should consider allocating to that area of the market.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.
Index Definitions:
S&P 500 Index – This Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
S&P 500 Dividend Aristocrats Index – This Index tracks companies within the S&P 500 Index that have a record of raising their dividends for at least 25 consecutive years. Each company is equally weighted within the Index. S&P will remove companies from the Index when they fail to increase dividend payments from the previous year. The Index’s universe includes stocks with a float-adjusted market capitalization of at least $3 billion and an average daily trading volume of at least $5 million, in addition to consistently increasing dividend payments. The index requires a minimum of 40 companies.
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