Bonds, Safety, and Market Crashes

Welcome to the 2nd installment of “Nerdvember!”  If you want to catch up on last week’s nerdy article, click here for The Good, Bad, and Ugly.   However, these articles do not build upon each other, so there’s no need to read last week’s in order to understand what you’re going to consume today.  Speaking of, today, I want to teach you about risk in stocks, risk in bonds, and when we’re faced with a potential market crash, how that typically looks.  Alright, let’s talk some nerdy stuff!

Most people don’t really start forking money into their 401(k)’s and other retirement plans until much later than you’d think.  In fact, the last statistic I say said that the average person starts planning for retirement at age 52!  That doesn’t mean that they haven’t saved – it just means they don’t start getting serious about putting a plan together until then (on average).

My point isn’t to shock you with how late that is.  Rather, I wanted to set the stage for the fact that most investors today are used to “stocks being risky and bonds being safe.”  This is not the case anymore.

The reason bonds have been considered ‘safe’ investments is because, for the last 35 years, interest rates have been coming down, and when interest rates fall, bond values increase.  It’s that simple.

If we sprinkle in a little fear, risk, and a potential market crash (i.e. – people selling their stocks and putting money into bonds), what you end up with is more selling enthusiasm, which sends stocks down faster, and more buying enthusiasm on the bond-front, which would send bond investments even higher than the falling interest rates were already taking them.

Today, we live in a very new environment for the vast majority of investors.  Think about it – most retirees today (never mind those who are still working) don’t remember a time when bonds performed poorly!  This is again, because interest rates have been falling for so long, it’s become (false) common knowledge that “bonds are safe” and “the older I get, the more I should have in bonds.”

Sure, bonds are still technically safer than stocks.  They have a lower standard deviation (which measures risk), so you can expect less volatility as well.  However… if the reason you’re investing in bonds is to have a portion of your money allocated to “safe” investments, it’s going to be incredibly difficult to set-it-and-forget-it this next several years.

Why?  Because chances are, interest rates have bottomed and while there will be intermediate ups and downs, the long-term direction of rates is likely to be up from here, not down.  This also means that the long-term value of bonds is likely to be down, not up.

Here’s a look at the bond market since September of 2017.  Ugly, huh?  This puts bonds down about -5.6% since then.  Doesn’t sound very safe anymore, does it?

AGG-1024x484 Bonds, Safety, and Market Crashes

So that’s our first of two lessons today.  Just because it says “bond” doesn’t mean it’s safe.  Buying bonds with a “Buy & Hold” strategy is going to be tough as interest rates continue to rise.  To piggy-back on that opinion, other fixed income classes need to be considered in addition to traditional corporate and government bonds.

It’ll be important to focus on the short-end of the yield curve (shorter-term bonds), as well as Floating Rate, which unlike traditional bonds, the value goes up when rates rise…. and whenever we start to see the CPI (Consumer Price Index) start to rise, considering TIPS (Treasury Inflation Protected Securities) and WIPS (World Inflation Protected Securities), both of which go up when inflation goes up.

So with that behind us, let’s move onto the next lesson of the day.  By the time you’re done reading the second half of this article, I want you to have a new perspective (a longer-term one, specifically) on market crashes like the ones we saw in 2000-02 and 2007-09.  So let’s start there… Fact:  “Markets don’t crash overnight.”

Okay, okay… there was Black Monday in 1987 when the market went down -22% in one day.  Sure.  That’s a pretty quick crash I suppose.  BUT… did you know that the market was down as much as -34% that year, and it STILL finished positive (up +6%) for the year?!  Check out the rest, below.  The market goes down quite a bit each calendar year, but many of these drops are mere corrections that we need to recognize as “normal.”

intra-year-corrections-1024x470 Bonds, Safety, and Market Crashes

But how do we recognize when a “correction” is turning into a “crash?”

Well, it’s not easy, I’ll tell you that much to start.  Also, there is no one, big red flag that pops out and tells you the market is going to crash, either.  In fact, there is absolutely nothing – so sign, indicator, or otherwise – that will guarantee a crash is coming.  Instead, we have to manage risk (or said a better way, “Manage how much risk we’re willing to take based on where the market is today, where it’s been recently, and where it’s been in the past).

If you’re a long-time reader of my commentary, then you’ll know that I like to take a weight of the evidence approach to risk and investment management.  There’s no “on/off” switch.  Rather, we have a “dimmer switch” – effectively “dimming down” risk and raising cash when risk levels become high and doing the opposite when risk levels fall to levels that are conducive to deploying cash and participating in the markets more heavily.

One of the signs that I look for is a negative divergence in something called the Advance-Decline Line (or AD Line for short).  In order to understand the AD Line, you have to first understand that the S&P500, Dow, and NASDAQ are all indices that fool you.  Reason being, when the market moves up or down, the biggest companies move those indices the most – and the smallest companies really don’t move them much at all.  Point being, it’s entirely possible to have half of the S&P500 stocks in crash territory while the S&P500 index is still going up!

So one of the things we want to analyze on a regular basis is how many stocks are going up vs. going down over time…and then compare that trend vs. the indices themselves and whether they’re going up or down.

I’m sorry if that sounds confusing, but basically, we don’t care so much whether “the market” is going up as much as we care about “how many of the stocks in the market” are going up.  Does that make more sense?

Think of it this way… if the generals are the big huge companies on the index that move the market the most and the troops are the hundreds of individuals going into battle, if we want to know this:

If the generals are still charging into battle, are the troops still behind them – or have they run away and retreated?!  If they’re still running with the generals, then the AD Line would follow pretty closely to the market indices (the generals).  But if the AD Line is diverging downward (troops are retreating) against a rising market (generals still running forward), that’s a problem, isn’t it?!

The following charts are compliments of my friend Ari Wald, CFA, CMT, head of Technical Analysis at Oppenheimer.  I’d normally just put these together from scratch, but he already constructed these a couple weeks ago, so why re-work perfection?!  😉

As you can see below, the AD Line has experienced lower highs in almost every single drawdown that occurred after 1980, 1987, 1990, 2000, and 2007.  Then, as you can see in the table in the bottom-right, “Declines were less severe (< 20%, or a mere “correction”) when the AD Line didn’t provide at least a 4-month warning (1953, 1976, 1994, and 2015).

Ari-Chart-1 Bonds, Safety, and Market Crashes

Ari-Chart-2 Bonds, Safety, and Market Crashes

Looking back at the most recent “crash warning,” you can clearly see how the AD Line printed lower tops and declined while the S&P500 continued to rise.  This was one of the many big reasons we took such caution with our clients’ retirement portfolios in 2015-16 leading up to the Presidential election.

Ari-Chart-3 Bonds, Safety, and Market Crashes

However, if you look at the far-right side of the chart, above, you’ll see that we’re not seeing that same divergence yet, which means that this warning sign is not flashing a red-flag, which also is one big piece of evidence suggesting this market likely has more upside before we see a big market crash.  And recall from prior articles, market crashes take around 1 ½ years from top-to-bottom.  So again, “They don’t happen overnight!”

Okay, while this is “Nerdvember,” I think 1,700 words is probably more than enough!  I hope you took some interesting knowledge away from this article and if you have any questions at all – even if they’re off-topic or personal questions about your financial situation, please reach out.

Meanwhile, try to stay warm this chilly weekend and have a wonderful time with your families!

Till next time…


Categories: Adam Koos, CFP®, CMT®, Market Commentary

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