In this week’s perusal of the news, this headline caught our attention …
Bank of America declares the “end of the 60/40” standard portfolio
Market Watch 10/15/19
We know it SEEMS like a pretty benign article … irrelevant to real estate investors. But au contraire mon frère …
There’s actually quite a bit of useful intelligence packed into BofA’s thesis.
Here’s what they have to say …
“Investors have long been told that the ideal portfolio should carry 60% of its holdings in equities and 40% in bonds, a mix that provides greater exposure to historically superior stock returns, while also granting the diversification benefits and lower risk of fixed-income investments.”
This, as they say, is “conventional wisdom” for paper portfolio strategy. It’s basically a straddle between principal risk (stocks) and safety of principal with income (bonds).
Except in today’s topsy-turvy financial markets, BoA admits this no longer makes any sense …
“ ‘The relationship between asset classes has changed so much that many investors now buy equities not for future growth but for current income, and buy bonds to participate in price rallies,’ [says Bank of America] …”
Stocks for income and bonds for price speculation? That’s a substantial role-reversal.
Before we dive into the real estate ramifications, let’s dig a little deeper into the essence of their position …
It’s easy to understand the first part … an ideal portfolio hedges both inflation and deflation while positioning for equity growth, yield, and protection of principal.
Of course, real estate can do all that MUCH better than stocks and bonds. But we’ll come back to that in a moment.
The bigger revelation in this article is BoA’s admission that paper assets aren’t working properly right now.
This is something most Mom and Pop investors (and their financial advisors) aren’t fully aware of. If they were, this BoA research note wouldn’t be newsworthy. But it is and that’s telling in and of itself.
Here are the problems in a nutshell …
Bonds are producing next to no yield. They’re next to useless for the production of income, as any pension fund manager can tell you.
Bonds are in a bubble … significantly over-priced. That’s why bonds produce no income …
(A bond’s price is inverse to its yield, so low yield equals high price … and ridiculously low yield equals ridiculously high price.)
When any asset price exceeds fundamental valuation, there’s a possibility … in fact, a high probability … the bubble will deflate, and the price will fall.
This means as a vehicle for adding income and preservation of capital to a balanced portfolio, bonds are failing on both counts.
Bonds have now devolved into nothing more than gambling chips for speculators in the Wall Street casinos …
… and tools for economic intervention vis-à-vis interest rate manipulations by central banks.
In fact, it could be argued that central banks aren’t even focused on the economy. After all, why lower rates when the economy is “booming”?
More likely, the financial system is far more fragile than anyone cares to admit … and central banks are trying to prevent collapse.
Remember, bond values are inverse to yields. If rates rise, bond prices fall.
With TRILLIONS of dollars of bonds leveraged throughout the system, falling bond prices could trigger a chain reaction of margin calls.
Think 2008 on steroids.
Once you understand all this, the logical conclusion is …
“ ‘there are good reasons to reconsider the role of bonds in your portfolio,’ and to allocate a greater share toward equities.
By now you may be thinking, “So what? I’m a real estate investor. I don’t own bonds.”
Smart. But most real estate investors make liberal use of credit markets. When bonds implode, they often take credit markets with them.
Real estate is a lot more challenging when credit markets are broken. And it’s downright deadly if you’re not structured IN ADVANCE to weather frozen credit markets.
But why does BoA sound the alarm now? Because …
“ ‘…this is happening at a time when positioning in many fixed-income sectors is incredibly crowded, making bonds more vulnerable to sharp, sudden selloffs when active managers re-balance,’ ”
In other words, as portfolio managers wake up to the risks of bonds and scramble to get out before the crowd … they become the crowd … and WHAM, the bottom falls out.
The credit market collapse of 2008 converted us into avid bond market watchers. But there’s also some opportunity here.
The core message of the BofA research note is …
“ [BoA] advise[s] investors to add more exposure to equities, particularly stocks with high dividend yields in under-performing sectors … which can be bought at inexpensive valuations.”
To translate this into real estate investor …
Stocks or “equities” represent ownership in operating businesses.
In real estate, operating businesses are things like an apartment building, a self-storage complex, a mobile-home park … or on a small scale, a rental home.
“Dividend yields” are operating profits distributed to shareholders … just like real estate rental income distributions to property owners.
“Under-performing sectors” could be likened to regional real estate markets or product types and price points which aren’t over-bid.
Of course, BoA doesn’t speak real estate investor, so they’re talking paper assets.
But the economic conditions they see and the actions they recommend in response not only make sense, they make the case for real estate investing.
After all, real estate provides a hedge against inflation. Over time, as the currency loses value, real estate’s value denominated in currency tends to rise.
And FAR better than bonds, whose yield is fixed, rents also tend to rise over time in response to inflation.
Of course, if deflation occurs, the value of the income stream becomes more valuable. And as prices fall, tenants purchasing power increases.
And even if a property falls in value 40% and never comes back (unlikely) …
… if you only put 30% down and the tenants eventually retire the 70% loan, you’re still “up” … apart from the tax breaks and cash flow along the way.
Best of all, real estate investors can use lots of relatively inexpensive long-term debt without fear of a margin call.
Of course, mortgages are only available when credit markets are healthy, so now’s arguably a good time to stock up on cheap long term debt.
However, just because real estate is awesome, it doesn’t mean real estate is without risk. Pay close attention to cash flow.
Still, compared to nearly every other investment vehicle, real estate arguably offers a lot less risk and more resilience against a variety of economic changes.
And unlike stocks and bonds which are essentially commodities traded in global exchanges where it’s hard to find a “hidden deal” … real estate trades in extremely inefficient local markets.
And because every property, neighborhood and ownership is unique, it’s much easier to buy a property at an “inexpensive valuation”.
So whether you’re only investing in your own account, or profiting from sharing your expertise with other investors, it’s encouraging to realize …
… real estate is a powerful solution to the challenge of building a resilient portfolio in changing times.