Q3 2020

October 1st, 2020

In my last letter, I recounted our experience working in downtown Minneapolis during the pandemic and demonstrations. I thought I had written in a tone devoid of emotion, as my intent was simply to chronicle a truly unique few months.

The fact I received more than a few calls of support to “cheer me up”, indicates my unintended tone was a bit dour. I can assure you that we here at Nicollet, like each of you, are plugging along just fine, hoping for a resolution.

I also wrote last quarter about how the stock market was recovering. You are undoubtedly aware that the market had exhibited tremendous strength in spite of weakened economic conditions. That strength continued through the 3rd quarter.

I cautioned you then and will reiterate here, the unusual circumstances driving the economy’s weakness make it very difficult to look at current valuation metrics to render a judgment on the strength. The measure as to whether the market is now “too high” or “fairly valued” will depend on the path of the recovery. Investors have clearly decided to ignore current conditions and buy stock based on an optimistic view of the recovery. We view that as reasonable. The economy has the potential to recover rapidly once this is all over.

I also discussed last quarter that certain companies are seeing business improve dramatically during the shut-down. There are two groups of companies benefitting. One group is seeing what I would call “cyclical improvement”. In this camp are the package food companies whose business is spiking because people are cooking at home. We do not expect these companies to see any permanent improvement in their business; once the pandemic’s effects end, their business will start moving back to where it was.

The other group of companies are those experiencing an acceleration in their business plans because of the shutdowns. We all know that online retail is one of those industries, but there are others. For these companies, all-time high stock prices are probably warranted.

The recent performance of the stock market reflects all this. If you look at the cover sheet provided with your statements, you will see the performance of four major stock market indices. It is not hard to see the divergences occurring in the market. Large cap growth companies are dominating the market this year, which reflects that second group of companies I mentioned above.

As for the fixed income market, interest rates remain at low levels and will likely remain low for the foreseeable future. The Federal Reserve is highly unlikely to move rates up until the economy has fully recovered.

This raises a question: is it foolish to invest in bonds when rates are this low? The answer is no but warrants explanation.

If we group our investment options into two distinct categories, we would label them bonds and equities. The distinction between the two is quite simple.

Bonds carry with them a contractual obligation on the part of the issuer to pay interest and ultimately repay the face value of the bond to the investor. The return earned to maturity on a bond is known and the obligation a promise.

The other group, equities, includes all sorts of investments. An investor’s return on equity investments is comprised of two components: dividends paid and capital return. Neither is guaranteed nor an obligation of the issuer.

As you well know, we use bonds in accounts to fund expected withdrawals and provide diversification. Do low-interest rates invalidate these purposes for bond investing? The answer again is no.

However, it is very tempting when interest rates are so low to look for higher income from other investments. Acting on this singular focus on income always leads to increased risks. Almost all high-yielding investments today are equity investments that lack the important contractual obligation to pay.

But that is not the only reason to stick with bonds. You must always keep in mind what happens to the markets when current conditions change. If down the road, interest rates begin to rise, we would expect the prices of both bonds and equities to fall.

However, if you own bonds that are structured so you can hold them to maturity, you will not experience a loss on those investments. When rates rise you experience a temporary paper loss on your bonds, but as they mature you will realize the return expected when each bond was purchased.

As for equities, rising interest rates will cause prices to fall. We would suggest that equity investments purchased for yield will likely fall more than the general market. As rates rise, the premium paid for the yield will be worthless and prices will fall accordingly. When replacing your bonds with higher-yielding equity investments, you are exposing your portfolio to a higher risk of capital loss should interest rates rise.

What if current low rates persist indefinitely? In that case, it may well make sense to switch out of fixed income and into higher-yielding equities. However, we would caution anyone against risking their portfolio based on this sort of prediction; the risks to capital are too great.

Our recommendation to stick with bonds is not all for defensive reasons. If rates remain low, the stock market will continue to put a premium on growth. In a low rate environment, we would expect companies capable of delivering strong growth to deliver higher returns over time.

If we put this in the context of your whole portfolio, even though you may be accepting a low interest rate on your bonds, your stocks should continue to deliver good performance. That is, the total return of your portfolio should still be good. That is what we have seen over the past 10- years.

Recognizing that low-interest rates create an incredible temptation to find “better” investment options, we recommend sticking with your mix of stocks and bonds. That mix was constructed based on your specific circumstances and is not invalidated by low-interest rates. Let’s make sure the money you need in the short- to intermediate-term is invested appropriately and not put at risk. Let’s keep the focus on total return and not just yield.

With that, I wish you a very happy Fall and look forward to seeing you in person (hopefully) soon!

Sincerely,

Mark Hoonsbeen, CFA
Principal