The yield on the 10-year US Treasury recently touched 1.6%, its highest level since the COVID-19 shutdown. Why are rates rising? 1) economic data is improving, and 2) the market is optimistic about the reopening of the global economy. Are rising rates bad for your portfolio?
Our view (which I believe is different from others) is that rising rates should not be bad for your portfolio if you are properly diversified. Meanwhile, market pundits are arguing that it is a doomsday scenario. I think the problem is that many investors have extrapolated previous returns into the future and believe unprofitable technology stocks (i.e., “hopes and dreams” stocks) and bonds will keep going up forever. As my mentor once told me, “everything works until it doesn’t.” So true!
Our advice: don’t be so rigid in your portfolio design. Markets are forward-looking and move based on the rate of change. Nearly all investors are active managers. And if you are active, then you might as well have a forward-looking view and rebalance when there is a clear trend.
Why are rising rates bad for technology stocks?
When interest rates rise, the present value of future cash flows decreases which in turn causes long duration assets to decline in value. We can show you a DCF analysis in excel if you wish.
- In particular, the discounted long-dated earnings of growth stocks become less attractive as interest rates materially rise. This is a key reason why the NASDAQ-100 Index just went negative on the year. In recent months, market participants have been selling technology and rotating into more value-oriented names, particularly cyclical stocks like energy, industrials, financials, and materials. This trend can continue in our view.
- With regards to energy stocks, I remember the days when the sector made up 25% of the S&P 500. Today, it makes up around 3%.
Technology stocks are interesting. They are arguably the longest duration stock as most tech companies invest in producing future cash flows and do not pay dividends in the short term. Meanwhile, dividend yielding stocks (arguably, the shortest duration stock given they pay out cash flows every quarter) have been outperforming technology stocks. We all know that nominal Treasury bonds will underperform if rates rise. But some parts of the bond market will do okay in a rising rate environment (i.e., bank loans and floating rates).
The reality is that there is a lot of concern about rising rates because portfolios aren’t properly diversified. Investors have been overweight technology stocks and bonds (both have had incredible Sharpe ratios over the past decade) and are relying on the stock/bond inverse correlation to hedge their portfolio in the future. Moreover, investors are overweight market cap weighted indices which have a heavy technology bias.
Astoria’s portfolios, on the other hand, have been much more diversified across factors (translation = we don’t have a large tech bias) and have been underweight bonds for years. We have been utilizing alternatives (which generally do well when there are large market dislocations) since we opened our doors. Lastly, we have gradually been adding inflation hedges to our core ETF models in recent quarters as they were cheap and “carried well”.
Ever since the market began pricing in an interest rate hike, stocks have been wobbly. Since Q1 2020, the Fed has indicated they would keep rates low for the foreseeable future. All along, stocks have rallied as investors have modeled that rates would stay low for an exceptionally long period of time. Now that has started to change.
Should you sell your bonds or technology stocks? We have been encouraging advisors to begin transitioning their portfolios. Followers of Astoria’s research will know that we have been tilting our portfolios towards inflation sensitive and cyclical assets (a 10% sleeve does not meaningfully change the standard deviation for a balanced allocation; ask us for our research). Certain tech stocks with profitable businesses, high profit margins, high free cash flow will probably be okay in the long run. But we would caution unprofitable tech start-ups and the ever so loved “hopes and dreams” stocks.
Astoria’s Inflation Sensitive Portfolio has allocations to energy, materials, financials, industrials, commodity equities, physical commodities, and TIPS and is available in SMA format or model delivery. We have invested in trading technology which allows us to seamlessly blend a balanced portfolio to incorporate this important macro sleeve. Contact us if you would like to discuss a physical sub-advisory relationship.
If you are not ready to sleeve your portfolio for thematic strategies, we would suggest using Small-Caps, Mid-Caps, Emerging market equities, and Developed International equities in the core portfolio. We don’t think it’s too late to own these assets. What should you sell? That would require a deep portfolio diagnostic analysis which we are happy to do. Shameless plug: Astoria has invested significant amounts of time and money to generate in-depth portfolio diagnostic reviews. Please reach out to us if you would like this.
My bottom line: Do not be so rigid in your portfolio design. The market is telling you that the trajectory of rates is higher. You have made good money being long technology, market cap weighted ETFs, and bonds in recent years. Don’t overstay your welcome!
Here are some of our detailed portfolio construction thoughts in recent months:
Astoria’s Portfolio Construction Thoughts (click here)
Massive ETF Flows Continue! (click here)
Cyclicals for Short Term Alpha (click here)
Portfolio Construction Thoughts as we Head into 2021 (click here)
CNBC Interview: Top Investment Strategy Views for the Second Half of 2020 (click here)
Astoria’s Investment Committee Quarterly Report: Increasing the Cyclicality of our Portfolios (click here)
The Economic and Earnings Cycles are More Important than the Presidential Cycle (click here)
Two more things:
We updated our portfolio construction dashboard tool, which contains all our portfolio holdings, factor risk exposures, tilts, performance, attribution, and more. Click here to view our dashboard or email us if you wish to gain access.
We recently did a 20-minute interview with ETFaction.com highlighting our investment process. You can check out our interview here.
Best,
Astoria Portfolio Advisors
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