Sector Allocation is Most Responsible for Market Returns
It is an established fact that returns on investment are more attributable to sector allocation than all other factors. The financial successes of Benjamin Graham, known as “the father of value investing”, and his star pupil, Warren Buffet, are largely ascribed to their respective and predominant appropriation of invested assets to the single industry of property & casualty insurance. Myriads of investors have been bankrupted for concentrating precious capital to single, ill-timed ventures; in fact, the regional bank failures of 2022 were caused by the disproportionate allocation of reserves to long-term Treasury bonds immediately preceding the biggest rate hikes in 40 years. The examples proving the supreme importance of sector allocation are innumerable. Consider how market dynamics today indicate a considerable reallocation of investment holdings may now be advisable, a concept stock investors have thus far noticeably failed to perceive.
Low and perpetually declining interest rates in recent decades, in particular from 2009-2021, discounted present cash flows and placed a premium on future cash flows. This caused businesses to build things they’d otherwise not have built, and led to unprecedented mal-investment. It also encouraged investors to abandon fixed-income securities in favor of stocks and other riskier ventures, and led to new records in borrowing and leveraged investing.
We believe ultra-low interest rates are unlikely to return for several reasons. Low rates weaken the dollar, already experiencing deteriorating confidence globally due to America’s unpayable debt load. The Fed recognizes its error of keeping rates too low for too long and is unlikely to soon repeat the mistake. Inflation has reached the dangerous stage of entering the mindset of consumers and will likely re-surge if rates decline.
Higher rates mean lower corporate profits, which tends to diminish asset appreciation. It also makes borrowing and avoiding default more difficult for profitless and heavily indebted companies.
While certain assets are more challenged in a higher interest rate environment, others, like lending, credit, and fixed income investing benefit. Today fixed income investors can receive a positive real (after inflation) return on cash instruments, like CD’s, money market funds and Treasury bills, and hope for equity-like returns from non-investment grade debt instruments. Famed investor, Howard Marks, refers to the new dynamic of higher rates as a “Sea Change”, one he believes will last, and is, therefore, worthy of your observation as an investor.¹
It stands to reason that if market dynamics have fundamentally changed, the best performing investment strategies before the change will likely be replaced by a very different list of winners. The evidence for sustainably higher interest rates suggests that credit, an asset class loathed by investors in recent years, may now be worthy of a larger portion of an investor’s capital.
Wise investors “lean”, they do not jump. This is not a call to abandon stocks, especially the ownership of great, capital-efficient businesses! Rather, it is an observation of a significant, and probably lasting change in the investing landscape. It’s also a call to consider a corresponding and prudent sector reallocation, the investment factor most influential to future returns. Think about it, Shaun.
“Give a portion to seven, or even to eight, for you know not what disaster may happen on earth.” ~Ecclesiastes 11:2
1 Oaktree Capital, ‘The Memo’ by Howard Marks, “Further Thoughts on Sea Change”, October 11, 2023
The opinions voiced in this material are general, are not intended to provide specific recommendations, and do not necessarily reflect the views of LPL Financial.
Bonds and other fixed income investments may result in the loss of both interest and principle in the case of a default. Rising interest rates result in a lower present value of held bonds. Par value and the return of principle is sure only if bonds are held to maturity.
Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Because of their narrow focus, investments concentrated in certain sectors or industries will be subject to greater volatility and specific risks compared with investing more broadly across many sectors, industries, and companies.
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