- With stocks and bonds at historically high valuations and low yields, many investments are offering negative real returns.
- Lost decades are actually a regular historical occurrence, but many of today’s investors are not positioned accordingly.
- I discuss alternative assets and real assets as a way of hedging against risk and building an “all-weather” portfolio.
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The majority of assets today continue to trade at or near all-time highs. With such an expensive environment, we must be cautious of what performance will look like going forward.
Many investors are just now becoming aware of how expensive the stock market currently is, with the S&P 500 (SPY) hovering around a PE of 34:
Does this mean investors should turn to bonds instead? Unfortunately, the bond market is in a similar situation. The 10-year treasury (IEF) is yielding just 1.2% - a negative “real yield” after taxes and inflation are accounted for.
Corporate bonds pay double the yield, around 3%, but also carry at least double the risk of a government bond. And of course, even a 3% yield is a negative real yield in our high inflation environment.
Even Legendary Investors are Concerned
Thus, it makes sense that many legendary investors have expressed caution about the overall condition of the economy. Even Warren Buffett, who famously advises investors to “never bet against America” is holding an extremely high allocation to cash for Berkshire Hathaway, and has acknowledged the risk of changing interest rates.
Ray Dalio of Bridgewater fame has been more explicit, calling for the possibility of a lost decade in which investors may achieve near-zero returns for the foreseeable future. He has been particularly concerned about corporate debt levels and US-China affairs.
Jeremy Grantham’s outlook is bleaker. He has compared current conditions to the dot-com bubble of the early 2000s and thinks it is only a matter of time before the current bubble pops.
Of course, there are also Michael Burry’s infamous twitter warnings, which have now been mysteriously deleted. Burry predicts extreme levels of inflation and a huge crash:
Source: Twitter (TWTR)
All of these investors are correct that many market indicators point to the possibility of very low or no returns going forward:
COVID has forced some companies into excess debt.
Inflation and CPI figures continue to rise.
Interest rates will likely rise as well.
Profit margins are falling in many industries.
High valuations allow for very little margin of safety.
How to Protect Against A Lost Decade
Despite sounding like a doomsday term, “lost decades” have actually been somewhat commonplace historically:
However, most investors are not excited to hear about the prospect of a decade of lost returns. So how can we protect our portfolios against this possibility?
The old school solution was the 60/40 stock/bond portfolio split:
Source: Author's creation
However, we discussed the problem with stock and bonds earlier. Bonds currently offer a negative real yield, so there’s little incentive to invest in them. And do you really want 60% of your portfolio in equities when the stock market is trading at bubbly valuations? Likely not.
So what’s the alternative? Well, it depends who you ask...
Some investors, like Buffett, are holding large cash positions. Of course, this cash is being eaten away by inflation, but it also allows one to take advantage of low prices in the event that we do have a large crash or liquidity crisis.
Other investors have fled into digital currencies like Bitcoin (BTC-USD), in search of an uncorrelated asset and inflation hedge.
Cathie Wood from Ark Invest (ARKK) believes that innovative technology companies will offer the most outsized returns going forward.
Bruce Flatt, on the other hand, has turned to real assets and physical infrastructure.
While the strategies above are all a bit different, we can see a common theme: a turn towards alternative assets, and away from the broader stock and bond market.
Brookfield (BAM) has called for this trend to grow exponentially over the next 10 years, with investors fleeing equities and bonds for either real or alternative assets:
If this shift is as wide-scale as they predict, it would result in a rotation of trillions of dollars worth of capital:
Obviously, this new rush of capital will propel real and alternative assets to new highs.
Ideally, one would want to be positioned in these asset classes before this mass rotation occurs. However, many investors are still married to the traditional 60/40 portfolio and mainstream portfolio allocation.
What Am I Doing to Prepare?
It’s more important than ever to have a portfolio of non-correlated assets, diversified across many sectors and asset classes.
Personally, I’m heavily allocating to real assets, specifically essential ones. This includes things like:
Energy transport companies and MLPs
eCommerce & industrial warehouses
Agriculture and farmland
As a result, the asset distribution in my current portfolio looks something like this:
Source: Author's creation
The benefits of real assets are becoming clearer and clearer by the day.
These assets offer:
High, stable yields,
And also act as an inflation hedge.
The point on reasonable valuations is perhaps the most important.
So not only are these real assets offering attractive yields, they also have upside and recovery potential as the world continues to return to normal.
I’m continuing to scoop these up while they offer market-leading yields, and hold onto them while waiting for future capital appreciation.
Many world-class companies in the real asset sector are still on sale, and you could build an excellent, high yielding portfolio by choosing to invest in a few of these undervalued companies. Of course, if you don’t wish to spend lots of time researching specific REITs, you could simply take positions in ETFs such as Vanguard’s Real Estate Index ETF (VNQ). This way, you’re placing a relatively simple, diversified bet on the sector as a whole.
You’ll notice throughout this article that I didn’t advise anyone to dump all of their stocks or bonds. I’m a long-term investor, and believe that for most people, timing the market is a fool’s errand.
However, if you are wondering where to allocate capital in the current environment, I would point you toward alternative assets, and ideally, real assets. Allocating appropriately will help you construct an “all-weather” portfolio that is well-diversified for the unique economic situation we continue to find ourselves in.
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This article was written by
Samuel Smith is Vice President of Leonberg Capital, he has a diverse background that includes being lead analyst at several highly regarded dividend stock research firms. He is a Professional Engineer and Project Management Professional and holds a B.S. in Civil Engineering & Mathematics from the United States Military Academy at West Point and has a Masters in Engineering.Samuel runs High Yield Investor investing group. Samuel teams up with Jussi Askola and Paul R. Drake where they focus on finding the right balance between safety, growth, yield, and value. High Yield Investor offers real-money core, retirement, and international portfolios. The services also features regular trade alert, educational content, and an active chat room of like minded investors. Learn more.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of BAM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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