Over the last few months, I’ve written often on the mispricing of safety-oriented investments. In early August, I recommended that Financials were a good alternative to hedge interest rate risk. At the time, it was easy to spot how the quest for dividends in a low-yield world caused many overvalued investments. Last month, Utilities, Telecom, and REITs all experienced sharp price corrections. The S&P 500 was virtually unchanged in August, but under the surface, investors began to brace their portfolios for a rise in interest rates. Money rotated into the Financial and Technology sectors as investors turned their focus to earnings and valuations. These two sectors had underperformed for much of 2016. The chart below shows the dramatic shift out of Utilities and Telecom.
I continue to believe that the major risks are political and central bank uncertainty. I’m less worried about the economy and more focused on avoiding investments that will implode once inflation returns. The biggest risk for retirees continues to be low interest rates and the risk of inflation increasing. The lesson learned in August was how low risk, interest sensitive investments can experience significant losses over a short period of time.
I believe that valuations, earnings, cash flows, and asset growth are better metrics that retirees should be basing their investment decisions on. Owning high-quality companies, that provide stable and growing cash flows, is a better way to invest over the long-term. Unfortunately, these companies are no longer cheap and it is challenging to find attractive entry points to buy. You are now buying high with the hope that these investments will go higher.
I’m no longer bearish on utilities and telecom, but I do believe that these sectors remain vulnerable. After a 8% correction, some of the downside risk has diminished. The U.S. consumer is very strong and this bodes well for future economic growth. Residential house prices are appreciating fast, gas prices are low, 401k’s and retirement accounts are high, and jobs are plentiful. We are in the late stages of the economic cycle when inflation begins to creep into the equation. Price inflation is already present in assets such as stocks, bonds, and real estate. Health Care costs have also risen dramatically and is running at 6-8% per year.
For those living on fixed budgets, rising costs without a hedge to inflation could result in a budget short-fall. For my retired clients, I have slowly adjusted my portfolios into sectors that may benefit from a rise in inflation. For my younger clients, I continue to hold higher quality technology and growth companies.
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Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.