Why Your Balanced Fund Could Be in Trouble

Traditional portfolio theory suggests that splitting your investments into a balanced portfolio between stocks and bonds is a smart and prudent approach to investing for the long term.

The theory is that you get some of the capital gains of stock as well as the income (yield) from bonds.

While this sounds like sound logic, you might want to consider what happens in a period when the balance in your balanced fund breaks down – like right now.


Bonds and Equities are Positively Correlated (Usually) – Why Your Balanced Fund Could Be in Trouble

Looking at a weekly chart of the SP500 equity index in the US, and comparing it to the TLT bond price ETF we can observe some interesting characteristics and behaviors:

  1. When stocks (the green and red candle chart) are going up, bond prices move in the opposite direction (blue line) (this is known as negative (inverse) correlation, and shows at the bottom of the chart in the red graph)
  2. When stocks are going down, bond prices move up, again, in an inverse direction (this is also an example of negative correlation)
  3. We can see that since 2007, there have only been 3 periods where bonds and stocks moved in the same direction for longer than a few weeks (positive correlation, the red chart goes above 0), and one of those periods is right now!
  4. We are seeing the first example of sustained positive correlation to the downside (equities and bonds are moving lower together)



What Does this Mean for Your Balanced Fund?

This means that both stocks and bonds are dropping in value at the same time.  Instead of getting a balance, we are in a period of both asset classes generating losses simultaneously.

This positive correlation period is worrisome for all market participants.  It has been a very tough year for actively managed funds, as they are struggling to find assets that can generate positive returns and have negative correlation to markets for diversification benefits.

But, why exactly is it so important to have negative correlation?

So you can create a balance and diversify your holdings so that in the event one asset class sinks, the other picks up the slack and offsets the losses partially or in full.  At the moment, most assets are heading lower together – stocks, bonds, oil and even the US dollar and gold.

The bad news is that this trend is expected to continue through the next few months.


What Impact Will a Rate Hike Have on Your Balanced Fund?

An increase in interest rates can come as early as Wednesday November 2nd of 2016, although it would be considered a surprise from the Federal Reserve.  The markets are currently pricing in an 8% chance that interest rates are raised this week.

In the last Fed meeting, there were three Federal Open Market Committee (FOMC) officials that dissented with the decision to keep rates unchanged.  It seems that the confusion in the markets extends behind the closed doors of the Federal Reserve as well.

The market is currently pricing in a 75% chance of a rate hike when the FOMC meets December 13th to the 14th.  In the event of an increase in interest rates bond prices will fall further along with equities.  The last rate increase in December of 2015 led to the worst start of any year in the history of equities. (12% decline in 50 days)

The bigger question however, is what the Federal Reserve projection for 2017 and beyond will look like.  How far will interest rates rise, and how fast?  The higher and faster the forecast, the more bonds and equities will fall in response.

A rate hike can have a double negative impact on your balanced fund in the event of a rate hike.

This could be a great time to speak to your financial adviser and review the composition of your portfolio.  Or even better, this could be a great time to start managing some of your money on your own.  Who would make better decisions with your own money than yourself?


Where to Find Safety and Diversification

For the long term investor, statistics show that holding a balanced fund for the long term will be profitable, eventually.  However, this is just a generalization based on the premise of past performance.  These markets are not your grand father’s markets, we are in unique times with the excessive Central Banking intervention we have seen in global markets.

Since the first fiscal stimulus package was introduced in the US on November 25th of 2008, the market is walking down uncharted territory.  Most will not know this, but Japan tried a similar experiment in the early 1990’s, and have not been able to raise their interest rates since.  In fact they now have negative interest rates and their asset values continue to decline.  The US may be walking down an identical path.

The Federal Reserve in the US is in a damned if you do, damned if you don’t predicament.  If the Fed hikes interest rates, it will send assets crashing (along with your balanced fund) and could spark a recession.  If they do not hike interest rates, assets will continue to inflate and make the eventual drop even steeper, albeit later on.  How much further can you kick the can down the road?

What you want to look for in a low interest rate and low-yield environment is assets that have negative correlation, and monitor this ratio regularly.  The problem is that there is very little negative correlation to be had in this artificially propped up market.

Gold and oil prices have followed the foot steps of equities and bonds in the past few weeks in anticipation of a hike.  Everything is slowly trickling down in value.


The Bottom Line – Why Your Balanced Fund Could Be in Trouble

Stock prices have skyrocketed over 215% since the post housing bubble crash low formed on March 2nd of 2009.  If you have caught some or most of the move, it is never a bad time to cash out some of your position and lock profits.  One third to a half is always a good split.  As I always say to traders and investors, no one has ever gone broke taking profits.

The alternative is to ride out the downside, which could be unpredictable and painful.  The problem with just riding it out is that we are in the middle of one of the biggest economic experiments of all time, and we could be approaching the top of the “central banking bubble”.  Do you really want to sit through a black swan like event?

The way I see it, a lot of the upside has happened, and the downside risk is far greater than the upside opportunity.  This is especially true if the Federal Reserve raises interest rates (75% chance currently).  If they don’t, the party goes on and equities will rip to new all time highs and the celebration continues.

Another option is to consider learning how to trade and manage your own portfolio and start taking advantage of price swings in markets.  Why?  Because you can protect your capital and even make money as markets fall.  The industry wants yo to believe that it is hard and that it takes a degree in finance.  It is not, and it does not.

The truth is that no one knows any better than you where the market will go.  Anyone that claims to know the direction is delusional or lying to themselves and you.  Forget about direction, start focusing on developing an action plan to take advantage of the upcoming volatility.  You no longer have to fear volatility, you can now make it pay you instead. (Read about trading volatile markets with the straddle options strategy).

Remember, profits come from execution, not predictions.  Good luck and stay green.


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The information contained in this post is solely for educational purposes, and does not constitute investment advice.  The risk of trading in securities markets can be substantial.  You should carefully consider  if engaging in such activity is suitable to your own financial situation.  TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.