(originally posted January 5, 2015 http://brightwoodventures.blogspot.com/)

“It’s tough to make predictions, especially about the future.”
-Yogi Berra

The US market finished up roughly 13.9% for the year, while US bonds were up .23% over the same period. At the same time, long-term treasuries returned 22.3%, something few if any were predicting at the start of 2014. Why do I bring up long term treasuries? Hold that thought, we’ll get back to it in a moment.




There is a good deal of talk about when and how aggressively the Fed will raise interest rates. This has caused many, including Eric Rosengren, President of the Boston regional branch of the US Central Bank, to go on record as saying of the current 2.15% 10 year rate as, “not a rate that is going to be sustainable in a completely normalized economy, which does imply the 10-year rate at some point in the normalization process will not be as low as it currently is.” (source: MarketWatch). Let’s unpack the issue here in a bit more detail. We know interest rate changes have a real impact on stock prices because fundamentally we value stocks based on the present value of discounted earnings. The ‘discount rate’ we use is impacted by interest and inflation rates (as well as future expectations of rate changes).




So, if the rates are going to go up, why don’t we get out of the market and avoid any potential issues? The reason, of course, is that it is difficult (some say impossible) to forecast the outcome. Rosengren’s comment implies a return to long term normal rates of 4+% for treasuries, but the absolute final level and even the rate at which rates will change is highly debated. Bill Gross has argued that with lower economic growth prospects, the ‘new normal’ may be lower than 4.5%. Others argue the Fed will wait a long time to raise rates. So back to the performance of long term treasuries this year, many argued investing in long term bonds at the start of 2014 would be foolishness. Yet, the long bonds beat the S&P500. By holding a diversified portfolio of asset classes we essentially smooth out some of the volatility that markets experience around interest rate uncertainty. Although I believe, based on long term projected population and productivity assumptions, that Bill Gross may be correct in his prediction that the US may experience a long period of lower rates, our first focus is on constructing portfolios that balance asset classes. The uncertainty that causes stock market volatility also causes bond volatility. However, over the long term, the price moves caused by interest rate uncertainty tend to cancel somewhat (bonds and stocks are not perfectly correlated).




There is another benefit to holding a diversified portfolio beyond not having to predict the future: It’s easier to sleep at night knowing that diversification provides a buffer to volatility in your portfolio.






Disclosure:

Outlook is not intended as investment advice. Investment allocations are unique to each client’s situation. This outlook includes discussion of historical results as well as models for evaluating possible future returns. Investing is inherently risky. We are not assuring or projecting any specific investment returns.