I'm not allergic to paper assets. To my mind there is nothing inherently evil about them - they serve a purpose, and when bought at the right price for the long term can provide very decent (even excellent) returns on investment. Ask Warren Buffet.
The rub, of course, is buying them at the right price. This has become incredibly difficult in recent years as the aftershock of post 2008 quantitative easing and near zero interest rate policies has seeped into equity and bond markets, inflating prices to levels that if not unsustainable are certainly unattractive.
Bill Gross, known as the "Bond King" and former manager of the PIMCO total return bond fund, the largest of its kind in the world, has voiced his opinion on the matter following a recent solid consumer spending report:
“Individual investors have little choice but look at real estate and gold given current bond yields, he said. “Bonds are not an asset, they’re a liability in a negative interest rate environment. Why would someone want to own them?”
The immediate thought is that it does not bode well when the guy who’s managed more money in the bond market than anyone alive publicly asserts that he thinks both bond and equity markets are overpriced.
For those unfamiliar with Gross however, it is worth noting that despite his outstanding long term record, he’s been touting that bonds are over-priced consistently for five years now.
The adage that "the market can stay irrational longer than you can stay solvent" proved accurate, as he was shown the door from PIMCO in 2014 to join the much smaller Janus group.
Whether or not Gross is right this time around, the reality is that if you're heavily invested in paper assets, particularly fixed income, you're potentially in a lot of trouble either way.
If he's right (which he will be eventually) then you stand to suffer considerable losses on your capital when the tide goes out.
If he's wrong (which is actually possible - Japan has wallowed with sub 1% bond yields for nearly 20 years), then you've actually got an even bigger problem, and it's a problem that could decimate the retirement planning of an entire generation.
Specifically, the problem is that retirement plans are almost universally modeled on an average future compounded return of approximately 7%. Gross, and countless other financial advisors argue that we now live in an age where we can't take that for granted.
There were nearly $25 trillion dollars in combined US retirement funds as of 2015, with the bulk (over 60%) in equity funds. The majority of the remainder is allocated to bond and money market funds, and other conservative options.
The issue is that as people age it is standard practice to shift the weighting from majority equities toward a more even allocation with bonds.
Although logical at the individual level (capital preservation and income take precedence over long term returns as we age), this screws everyone collectively when you've got an entire demographic bulge moving in the same direction.
Equities begin to slump as capital gets sucked away into less volatile, "safer" bond funds, while at the same time the money pouring into bonds forces yields down even lower than they already are.
It is difficult to see returns averaging 7% per year in this environment - equities cannot go up forever in the absence of earnings growth, and bond returns to date have been driven by the book value of longer term bonds rising as yields are bid down. These bonds will eventually mature, forcing funds to reinvest the principal at current, much lower market rates.
If, as Gross expects, we now live in a world where 4% is the new 7%, the compounding effect makes for an extraordinary gap between the already insufficient levels of retirement savings and what we can expect in the future.
A quick calculation tells us that $500,000 compounded at 7% for 20 years becomes $1,934,842. At 4% it becomes a meager $1,095,561 - little over half. These are nominal, non-inflation adjusted figures. Factoring inflation obviously makes things far worse.
Gross goes on to specifically suggest, almost surprisingly, that he favors real estate as a haven from this barren wasteland of low yields. It’s surprising because he has little to gain from talking up the real estate market and plenty to lose via redemptions out of his own Fund by talking down bonds.
Wall Street has not been asleep to the real estate idea, and large, class-A properties suitable for large REITs have already been bid down to absurd cap rates as low as 2.5% in some markets. Strip out the REIT's management fee (usually 2%), and you're again left with virtually no yield.
As smaller investors however, we have an advantage over the bloated institutions that currently subsist on cheap money and have little utility beyond extracting fees and commissions. We are agile. We are not liable to appease our boards. We are not slaves to quarterly earnings reports, and we need not worry about being fired by our superiors (unlike Gross).
Smaller investors are able to act independently and intelligently, moving into areas of opportunity and distress that larger actors cannot - or dare not - consider. We can attack smaller opportunities with greater yields, unconcerned about the need to seek assets and markets that can absorb billions of dollars. In short, against the big boys we may have less money individually, but we can make it work much, much harder.
If your financial planning has been based on an assumed 7% average compounded rate, as almost everyone's has, then the cold hard truth is that such returns must now be earned, not collected as a birthright. The market has for 8 years stubbornly refused to provide returns without prodigious quantities of cheap finance to fuel them.
Further, the returns on offer are almost entirely driven by capital growth, and achieving actual regular income without selling to capture it is near impossible. When money is cheap, the market doesn't care that you have it, and won't pay you to hold it.
Should such forced selling occur en masse, it creates a self reinforcing downward spiral that would ultimately restore value to asset prices and restore yields, but not before crushing the air from retirement portfolios. Catch 22.
What the market cares about now is finding new productive ways to deploy capital - and high yielding real estate is one area where the little guy has the upper hand. Real estate investors with specific market expertise are among the few that can reliably generate the returns they have planned for and are relying on.
Guest Author:
Aran Dunlop
www.dunlopcapital.com
If your portfolio has become bloated with paper and light on real assets (like real estate and gold), be sure to speak with your financial advisory team for some ideas to get back in balance.