“I love it when a plan comes together.” — John “Hannibal” Smith

If you’ve been around long enough to remember and appreciate that quote, you’ve been around long enough to understand and remember that it is not normal for stocks to advance in price month after month, year after year, with very little volatility.

“I love it when a plan comes together” because for the past few years I have encouraged readers to have an investment strategy which involves more than passive investing and riding inevitable market waves. I have also advised that the down wave is coming.

I can’t say for sure if this past week’s stock market volatility is the beginning of a bigger trend, nor can I say how long it will persist. However, I would like to use the recent reversal in stocks to review a few things that I have passionately written about over the last few years.

At least last week my plan is coming together.

Effective and skilled portfolio management does not include riding the ups and downs of a market under the assumption that “the market will always come back.” First, there is no guarantee that the market will bounce back within your investment horizon regardless of how long that time horizon is. Second, you can outperform the market by accepting a lower annual return while eliminating the volatility of your returns. In other words, target a lower annualized return, but eliminate big drawdowns, and you will outperform the market. You can do this with a skillfully structured portfolio.

Active trading can be part of an investment strategy. I suggest that the majority of your investment portfolio be structured to eliminate large drawdowns as described above. However, expressing a market view in a small part of your portfolio and making adjustments around the edges based upon probable market outcomes is well within the practices of prudent risk and portfolio management.

The US Federal Reserve engineered the remarkable stock market run which started in 2009. Ben Bernanke, the former Chairman of the Federal Reserve, said as much when he described the Fed’s “portfolio balance channel strategy.” The strategy involved driving the returns on safe-haven assets such as US Treasury bonds so low that investors would be forced out the risk curve. In other words, by driving bond yields to historical lows investors would be forced into stocks and other risky investments.

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The plan clearly worked, but did it pull the underlying economy along with it? There are recent signs that the economy is poised to grow at rate above the sub-par, below 3% rate of the last several years, but can that happen as the Federal Reserve unwinds their portfolio balance channel?

The Federal Reserve has started to reduce the size of their $4.5 trillion portfolio in US Treasury bonds and mortgage-backed securities which they acquired through quantitative easing as part of their portfolio balance channel strategy. Other global central banks have announced plans to do the same. Isn’t it reasonable to think that the strategy which drove stock markets to all-time highs and bond yields to all-time lows would have the opposite impact as the strategy is unwound?

The yield on the US 10 year Treasury bond is the most widely watched and important interest rate in the world. As the Federal Reserve raised interest rates over the past year and started to unwind their $4.5 trillion portfolio the 10 year Treasury bond yield has risen. However, the yield has not risen as fast as short-term interest rates. In other words, the yield curve has flattened. This is never an encouraging sign for the economy.

More recently signs of inflation have started to emerge, including wage growth. Leading up to the recent volatility and stock market selloff 10 year Treasury yields increased sharply. Part of this rise in yields can be attributed to the expected increase in supply of Treasury bonds. Even with the Federal deficit projected to move higher, on Friday the Senate voted to increase the Federal debt ceiling and increase both domestic and military spending which, all other things being equal, will increase the Federal debt even more and mean an increase in the amount of Treasury bonds issued to finance that debt. An increase in supply means lower prices, which means higher yields and interest rates. Stocks did not react favorably.

In conclusion, markets have been in a race against time. The US Federal Reserve clearly blew a bubble in markets. Market valuations have remained high under the theory that an improving economy would catch up with those high valuations. A hole was blown in that theory this week as interest rates rose and the bubble started to deflate. Market volatility exploded higher and funds and strategies betting against volatility imploded adding to the turmoil. Time will tell if this is the beginning of a larger move, if the recent stock market selloff will impact economic growth, and if markets and the economy can survive the wind-down of the Federal Reserve’s portfolio balance channel strategy. This part is certain; don’t let your portfolio bounce around like a tennis ball in the surf, and don’t let it go over the falls. You can do better. Have a plan.

Barry Nielsen has worked in capital markets for over 20 years with a focus on fixed income portfolio and risk management. He has an MBA from George Mason University and holds the Chartered Financial Analyst designation. He currently works for Opportunity Bank of Montana.

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