I spent the second half of my military career learning how to trade.
When I retired, I decided I wanted to manage money. Within four years, I got my chance.
I quit two years later.
Once you’re on the inside, you learn money management isn’t really about helping people. It’s about sales.
In the financial planning industry, one of the things advisors love to push most is the 60/40 portfolio.
They claim that this split, with 60% stocks and 40% bonds, is virtually foolproof.
And yes, it has a great track record over the past 40 years. Since 1982, it’s gained an average of 13.5% a year.
That’s nice. But we’re not investing in 1982, or any of the years that followed.
We’re in a new market environment. One where interest rates are rising rapidly, and the value of stocks and bonds are primed to fall.
Meaning in the coming years, the beloved 60/40 portfolio is doomed…
It All Comes Down to Interest Rates
The 60/40 portfolio has performed well over the past 40 years thanks to falling interest rates.
It may be hard to believe, but short-term rates were as high as 19% in 1981. For perspective, mortgages averaged 18.5% that year.
As interest rates gradually fell to zero, financial markets changed. Both stock and bond investors enjoyed big gains. Since 1982, gains have averaged 13.5% — compared to 10.6% in the years prior.
This is because interest rates and assets like stocks and bonds have an inverse relationship. As rates fall, the value of stocks and bonds go up.
To understand why, we need to look at how stocks are valued. In theory, a stock’s value equals the net present value of its future cash flows. Let’s break that down…
Say a stock earns $1 a share and will earn $1 forever. A dollar today is worth more than a dollar 10 years from now, or even one year from now. If you wanted to find the “net present value,” you would use interest rates to estimate the value of future dollars and add them all up.
The higher the interest rate, the less your dollar is worth in the future. The lower the interest rate, the more your dollar is worth. So, a stock that earns $1 per share is more valuable when interest rates are lower.
And not by a trivial amount, either. According to the formula, a $1 stock is worth about $5.26 with interest rates at 19%. With rates at 1%, that same stock is worth about $100.
Of course, in the real world, other factors affect stock prices. But the example above shows the powerful impact rates have on stocks.
Bond prices also gain when interest rates fall.
That’s because bonds issued today have to compete with bonds issued in the past for investor’s dollars. This competition means the current yield on similar bonds will always be the same.
An old bond issued at 19% pays $190 in interest for $1,000 every year. New bonds issued at 1% pay just $10 in interest.
An investor in the 19% bond will only sell if they can generate $190 in interest, even at 1%. That means they will demand $19,000 for their bond.
This dynamic has led to large gains in bonds over the past 40 years.
But when the process reverses, bonds, stocks, real estate, and almost every asset will suffer.
And with interest rates rising, this is already underway…
The Only Income Strategy Worth Following
Rates are rising, meaning stocks and bonds should both be worth less in the coming years.
Investors in a 60/40 portfolio face strong headwinds. Best case, they see lower returns than they expect. Worst case, they suffer large losses in the long run.
That’s something their financial planner said couldn’t happen. But the planner is looking backwards. We need to look forward.
There are alternatives to bonds that we could consider.
Take real estate. That’s a great way to generate income… If you already have plenty of money on hand. Real estate is a large upfront investment. It’s also expensive to sell. And it has holding costs with taxes and maintenance.
Dividend stocks are another income investment. But they face the same issue as the 60/40 portfolio. Rising interest rates will make stocks less valuable.
There are more exotic income investments as well, such as structured notes or real estate limited partnerships. But they all carry risks. Many are illiquid, and carry high fees.
Finally, there are options strategies that generate income. Two popular ones are selling puts and covered calls.
But, as Amber Hestla noted yesterday, there are serious problems with these strategies — problems many traders are completely unaware of.
That makes this a perfect opportunity to get an edge on the market.
There are two ways to do that.
For one, you can follow the only income strategy that should outperform in the years ahead. After months of research, Amber’s found a way to avoid the risk of being blown up that comes with almost every other income strategy. She’ll be sharing it with you later this week.
And two, you can embrace the volatility we’re facing. Adopt a strategy that can keep up with fast price swings, like Andrew Keene’s Trade Kings.
Andrew is in and out of most of his positions within an hour of the opening bell. Just last week, one member closed a trade after only four minutes… and walked away with an extra $4,000.
If you want a chance at gains like that, go here now to claim your spot in Andrew’s Trade Room. But be sure to hurry — the doors are closing tonight at midnight ET. There’s no telling when they’ll reopen…
Michael Carr, CMT, CFTe
Editor, True Options Masters