by David Maddux, CEO | CIO

We sent the following note to clients on September 5th.

Global Stock Diversification Is Working So Far this Year and Warren Buffett Is Stashing Cash

I wanted to share a brief update with you as summer has officially closed out and we shift to a new autumn season.

• International stocks have generated positive returns in recent years, but are particularly helping a diversified portfolio this year.
• Economy – seems to be rocking along, but investors seem complacent as some risk signals are flashing – including consumer credit and the tight interest rate spread between corporate debt and US risk free treasuries.
• Macro forces like tariffs, geo-political instability, Artificial Intelligence (AI) impacts and domestic political friction can each individually stir the pot.
• My focus remains on allocating from fact-based measures of value and erring on preparation over forecasting and allowing for flexibility.

International stocks have been an interesting positive so far this year as they are up 21.6%^ through August (represented by the All Cap World Index excluding US) while the classic US stock market proxies of the S&P 500 and Dow Jones Industrial Average are up 10.8%^ and 8.3%^ respectively.

Why this price change has occurred is hard to pinpoint, but the global economy has been signaling a low risk of recession (since January of this year per Ned Davis Research) and the US dollar has been depreciating against a basket of various currencies, which is a positive for US based investors in international stocks.

I have been re-reading Asset Allocation – Balancing Risk by Roger Gibson, for the fourth time, at least.  The foreword to the 1st edition is from Sir John Templeton, the famously successful “value” investor from 1954 – 1992, and the following nugget resonates –

Will this trend in international stocks continue or fizzle out like it did in early 2023 after showing some leadership?  My simple answer is I do not know and I may be jinxing this recent trend by writing about it, but regardless, remain focused on having a portion of the stock bucket invested internationally.  My view remains that these various international markets are fairly valued at an average Price divided by Earnings (PE) of 17 and Price divided by Sales (PS) of 1.7 vs. the US that is showing 26 and 3.3 on the S&P 500 (lower is better, all else being equal).  

Regarding the overall environment, I do not see anything in the economic data to highlight as some type of tipping point to a slowdown, but have a view that there is little margin for error in economically sensitive assets like stocks and corporate bonds.

Specifically on the domestic economy, the Federal Reserve Bank of Atlanta publishes their “GDPNow forecasting model [which] provides a ‘nowcast’ of the growth rate of the official [gross domestic product].”  This estimate is showing 3.0% annualized GDP growth for the 3rd quarter (https://www.atlantafed.org/cqer/research/gdpnow).  This model is a balanced prediction which makes the Fed’s interest rate strategy (to cut short term rates or hold) a tough decision.

Regarding the pricing of risk – a key area that I review regularly is the amount of interest that the lowest quality “Investment Grade” borrowers (BBB as opposed to AA) are paying compared to treasury bonds.  This chart below goes back 30 years and plots the interest rate difference or “spread” compared to treasury bonds.  The current ~1.0% spread is a historically low interest premium that these lower quality companies would have to pay, when the average has been closer to 2.0%.  An implication is that lenders are about as confident as they can be that there will be below average defaults amongst this lowest rung of the investment grade market (conclusion credit to Data Trek Research).

https://fred.stlouisfed.org/series/BAMLC0A4CBBB#

That does not imply that anything will change anytime soon, but with auto loan and credit card delinquencies at 18 year highs, as well as uncertainty around tariffs, we want to maintain both diversification within stocks, as well as some portion in short term risk free treasury bonds – especially for static portfolios or those distributing money for planned spending needs.  In other words, turbulence can happen at any time and once it gets started, we cannot know how long it will last until it is over.

Coincidentally, I have also been watching Berkshire Hathaway’s cash position grow to the highest in 35 years at almost 30% of total assets as Warren Buffett seems to be erring patiently (Cypress Capital).  This rising cash balance has historically been a marker for caution among Buffett acolytes.

In the spirit of being prepared for surprises, I want to share another nugget from Sir John Templeton–

Our average client is the most conservatively allocated to stocks since we started Brightwater 11 years ago.  This result is a function of a bottoms-up process at each client level, but is interesting to note.  Generally a favorable stock market over this time period has allowed for financial plans to have the flexibility to reduce the volatility of stocks and higher interest rates in the treasury bond market have provided an attractive alternative at the edges.  As a result, I have tried to hold the line on some mild underweighting toward stock targets since the summer of 2024, as risk seems mispriced and there seems to be a general complacency in investor psychology.

Please message me if there is anything I can clarify or if you want to compare notes in detail.  In the meantime, my focus remains on allocating capital toward fact-based measures of value and erring on preparation over forecasting, which should allow for flexibility to step through a variety of environments.

This letter is tonal in nature.  We use model portfolios and apply consistent thinking, but each client has a separate portfolio and there are many reasons for exceptions, like tax basis, planned distributions, heirloom holdings, preferences, size of the account, etc. 

Brightwater Advisory, LLC is an SEC registered investment adviser* with its principal place of business in Tampa, Florida.  This letter contains general information pertaining to our advisory services. The information is not suitable for everyone and should not be construed as personalized investment advice. This letter contains certain forward‐looking statements (which may be signaled by words such as “believe,” “expect” or “anticipate”) which indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward‐looking statements. There is no guarantee that the views and opinions expressed in this note will come to pass.

Investing involves risk, including risk of loss, which an investor must be prepared to bear.  We manage investments based upon factors which may include, but are not limited to, a client’s investment time horizon, income, net worth, attitude toward risk and investment knowledge. Therefore, it is important for clients to inform us promptly if there is a substantive change to his or her risk capacity, including financial situation. In addition, if goals and objectives have changed, please let us know immediately. Indices are unmanaged. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index.  

^Past performance is no guarantee of future results.

For additional information about us, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site.

*Registration as an investment adviser does not imply any level of skill or training.

The post Global Stock Diversification Is Working So Far this Year and Warren Buffett Is Stashing Cash first appeared on Brightwater Advisory.

We sent the following note to clients that was written on January 24th.

The 4%+ Bond Market – Opportunity or Risk?

Summary:

• Risk free treasury bonds are attractive any way I look at them and we continue to prefer a laddered approach in case inflation creeps higher again;

• Stocks exceeded their highs of 2021, but earnings have not kept up (they were $197 for the SP500 in 2021 and appear to have ended 2024 at $210) so they are even more over-valued by traditional fundamental metrics (price to earnings ratio of 24 in 2021 and now 28 – lower is better, per Ned Davis Research);

• Purpose of Investing – good investing is boring by design – serenity over anxiety;

• Brightwater Model portfolio – valuations and posture;

• Cyber-security – “Smishing;”

• Trusted Contact;

• We all need community.

My letter three years ago was about how the interest rate environment was changing and that was likely to affect aspects of the economy and other markets, like stocks.

That kind of happened.  Stocks ended up having a lousy 2022, but then recovered in 2023 and broadly set new price highs in 2024.  All the while, the economy never dropped into a recession as the rate of inflation gradually came down.

The full impact of higher borrowing costs seems like it has not been felt yet though.  This leads me to remain on notice for a drag on the economy and other growth assets like stocks.

Today, the Federal Reserve has cut interest rates three times since September from 5.33% to 4.33%, but the interest rate on the five year treasury bond has moved up over that same time period from 3.4% to 4.4%.

Why that is can be another line of discussion, which is interesting and worthwhile to think through, but for now I am highlighting that medium and longer term interest rates are not going down, in spite of the Federal Reserve reducing their short term, daily rate, a.k.a. “the Fed funds rate.”

The implications for me are two-fold –

1. Absolute basis – Risk free bonds are attractive based on their history (both nominally and when considering current inflation measures) and worth locking in;

2. Relative basis – Risk free bonds paying 4.4% is higher than the earnings yield on US stocks (SP 500) at 3.5%, as stocks are currently priced in their highest decile of historical valuations (Cypress Capital).

I went back ~100 years (from Ned Davis Research) to bucket the 10 year treasury bond (getting to be long term vs. 5 year, but not as long as a traditional 30 year mortgage) into what interest rate was reflected most of the time for each decade (median). 

The average over time was 4.8% with the 1970’s, 1980’s and 1990’s showing the highest decades.  The lowest were the 1940’s and the decade we just transitioned from.  If I drop the highest and the lowest decade from the mix, then the average median is 4.4%.  My illustration is to clip the extremes somewhat to see if it makes any difference, but it really does not – rates are fairly priced from this simplistic, historical look. 

Absolutely

The implication is that today a risk free interest rate is available for where it has been most of the time over 100 years of booms, busts, wars, new political regimes, etc. 

Can interest rates go higher because of inflationary pressures, continued deficit spending, hot economy, tariffs, trade wars, wars, etc?  For sure.  That has not been conventional thinking and I do not have conviction to make that case, but the way we allow for that is to use a ladder with individual maturities where a piece of the bond portfolio is designed to come due this year, next year, etc.  This approach allows some agnosticism on shorter term outcomes, but also flexibility to ratchet up the interest rate we are locking in if rates work higher the next couple of years.

Today the average maturity for our model bond sleeve is ~3.5 years and paying in the mid-4%.

Can rates go back down into the 2% range or lower?  Yes.  That would not matter in the very short-term though, as we have locked rates for a few years.  The implication is that there is little benefit to sitting too heavily in cash/money markets today vs. the 5 year treasury bond market.  For example, if rates move lower to 3% or 2% then a money market rate will drift lower in synch, where as a 5 year bond locks in the current rate of 4.4% for the duration of the five years and should be an easy asset to swap out if need be.  Again, a ladder helps here, as there are shorter term maturities coming due over the next one year, two years, etc. 

This context is a completely different setup than four and eight years ago for example when the medium term treasury market was paying 1% and money markets were effectively 0%.  Cash was a much better position to be in, because if you were in a 1% five year bond and rates move up from there, you are having to sell your bond at a loss in order to buy stocks or fund an unplanned distribution.  The challenging part was psychologically holding cash that paid nothing, as us old-timers were trained to get interest on our money.

Finally, if rates come down, we may wish that we had locked them in for even longer, but the more complex implication is that would likely come with an economic recession and stock prices being dramatically lower.  This would present a fresh opportunity to move some of the bond portion over to stocks for attractive expected growth from that point going forward.

Finally, finally – most every financial plan we have run for clients works much easier when risk free rates are paying anything north of 4%.  Everyone is unique, but simple algebra just means that risk free rates in that range relieve pressure off of the required return for stocks to pull their weight, as well as the heavy lifting for additional savings or longer years working for money.

Relatively

I just made the case that risk free bonds are yielding rates at their average levels over 100 years (i.e. not on the highest nor lowest side), but I cannot say the same about the stock market.  Certainly stocks can work higher the next few years, but the margin for error is razor thin.  Whether measuring them by classic ratios of price vs. the profits or earnings of the underlying companies (PE), price vs. the revenues or sales of the underlying companies (PS) or price vs. the cash-flows of the underlying companies (P-CF), the context is that valuations are in the highest decile of where they have traded over the last 100 years (Cypress Capital).  Eg – stocks were overvalued three years ago and are now more egregiously so.  The pathways to “fair” value again are 1) prices hangout while earnings grow in the coming years, 2) stock prices go down to align with earnings or 3) some combination thereof.

Positives for earnings should be lower interest rates as well a continued lower Federal government tax policy, but again the tension is how much of that expectation is baked into prices.

I can wax optimistically on some areas being fairly valued vs. overvalued or durable sector themes like Artificial Intelligence (AI), healthcare around the possibilities and disruption of weightloss drugs or the movement toward investing in sustainability, but broadly speaking stock valuations are at the highest decile of historical valuations, while bonds trade at the middle of their historical valuations and the bond market is paying better than the stock market on comparable measures.

Specifically, the dividend yield on US stocks (SP 500) is 1.2% and the earnings yield is 3.5% (which includes the dividend payout by definition as dividends are funded by earnings) is lower than the risk free 4.4% available in the 5 year treasury bond market.

The Purpose of Investing – Serenity over Anxiety

I have been re-reading a classic investing narrative entitled The Money Game written by “Adam Smith” (pseudonym) in 1967 during the melt up in the “Nifty Fifty” stocks (Polaroid, Avon, Eastman Kodak, Sears, Xeros, etc), which were the “must own” stocks of that era, as they performed fabulously. . .  until they didn’t. 

The narrator of The Money Game reflects,

“No matter what role the investor has started with, in a climax on one side or the other, the role melts into the crowd role of fear or greed.  The only real protection against all the vagaries of identity-playing, and against the final role of being part of the crowd when it stampedes, is to have an identity so firm it is not influenced by all the brouhaha in the marketplace…

Nothing works all the time and in all kinds of markets.  This is what is wrong with systems and the books that tell you You Can Make a Million Dollars.  What is important to realize is that the Game is seductive.  If playing it has been fun, it may be difficult to stop playing, even when that button of yours is burning your finger.  Repeated shocks will give you anxiety, and anxiety is the enemy of identity, and without identity there is no serenity.”

My point here is to foster awareness of what is the purpose of investing.  The obvious is to make money, but it can be challenging to resist over-owning assetst that have performed the best in recent years (stocks) vs. those that have been less exciting and possibly over-looked (risk free government bonds).

Valuation & Posture

Economically, there is an imbedded expectation that Trump’s pro-growth and government efficiency initiatives will be a positive.  Assuming they are, his latest term is starting out with the most over-valued stock market in US history, which is not a specific negative, as much as reflective that a lot of optimism is priced into the stock market and there is not much margin for error – or said another way, risk levels are high.

The following matrix reflects our Brightwater Equity model vs. the All Cap World Index, which comprises 67% US and 33% international, as well as the S&P 500, which is an index of the stocks of the largest US publicly traded companies.  By comparison, the Brightwater portfolio remains more fairly valued compared to these indices –

I am still on notice that the full effect of higher rates has not been fully experienced yet.  Basic examples for individuals are –

• mortgages (6.6% average for a 30 year per Zillow vs. almost half that rate in the years leading up to 2023);
• car loans (6.6% average for a new car per NerdWallet);
• credit cards (24.2% average per LendingTree).

For main street and the average publicly traded company it’s a somewhat different lens, as a borrowing proxy is only 5.5% (BBB rate per Federal Reserve Bank of St. Louis) which is only ~1% higher than risk free treasury rates.  The average difference over time has been closer to 2.0% (Ycharts) and another contextual point is that personal bankruptcy filings are at 18 year highs (Cypress Capital).  Again, the economy has been okay by most measures, but different measures of risk seem mispriced with little margin for error.

More from “Adam Smith” –

“…An investment counselor wrote a very interesting essay on investing and anxiety, for anxiety is the threat to identify. . . The end object of investment is serenity, and serenity can only be achieved by the avoidance of anxiety, and to avoid anxiety you have to know who you are and what you’re doing.”

We have a section on the first page following the Table of Contents on your Investment Plan Portfolio report in which we share our Investment Guidelines (the left panel is an attempt to periodically update custom notes on your moving parts) and one of them addresses –

“If the stock market declines from its highs, we intend periodically to re-balance your portfolio back to your target percentages in stocks.  To do so involves using some of the bonds and cash to add to stocks, which may go lower still, but this process is a methodical way to add to stocks during down periods.”

Per my note in October, our average client is about 10% underweight her stock target, so a 60% allocation to stocks is more like 54% as a mild erring on the conservative side.

I do not know what the future holds, but we are focused on what we can control, which in this case is implementing a simple, yet robust investment portfolio that barbells risk free interest rates on one end and long term growth or price appreciation on the other end, rooted in stocks that are fairly priced vs. over-priced.  This approach is adjusted for each client to fit with her season or unique circumstances. 

This approach fosters flexibility to address opportunities and challenges as they present themselves and hopefully, serenity.

Housekeeping

          Cybersecurity – “smishing”

Charles Schwab has alerted us of an active phishing text or SMS campaign in which clients receive a text message from an international number and it mentions a disbursement from the client’s account. It then asks to click on a link to log into their account to verify the transaction. Please review the red flags below to help clients identify if the text is a phishing attempt:

• The texts are coming from different international phone numbers.
• The texts notify that an ACH was debited from their Schwab account, typically in the thousands of dollars.
• The text then instructs the client to cancel the disbursement if they did not request it, by replying “Y” and clicking on the link provided.
• The link’s URL is a variation of a spoofed Schwab domain. For example https://schwbba.com, https://schwabd.com, https://schwbab.com, etc. 

My understanding is that Schwab has so many customers that the campaign is random as opposed to a targeted data breach.  As I remind myself, family, team and clients – basic security rules that I have come to understand are –

1. Use two-factor authentication on your email account, because that inbox is usually the link to any password resets on bank accounts, etc., etc;
2. Do not click on links regarding financial accounts. It is best to navigate directly to the website you are looking to go to.

Trusted Contact

A “trusted contact” is a person you authorize Brightwater Advisory and Schwab to contact at their discretion to disclose information about your account(s) to address possible activities that might indicate financial exploitation of you; to confirm the specifics of your current contact information, health status, (including physical or mental capacity), or the identity of any legal guardian, executor, trustee, or holder of a power of attorney on your account(s).

A trusted contact will not be able to view your account information, execute transactions in your accounts, or inquire about account activity unless that person has that authority through another role on the accounts, such as a trustee or power of attorney.

If you would like to add a trusted contact to your Schwab accounts and your Brightwater profile, please contact us to send you the form to update per your request.

Community – As the Formula for Fulfillment

Maybe it is because I am turning 50 this year and kid #1 of 3 shipped off to college, I am particularly reflective of late, but I keep picking up on signals from the universe about the critical role that community plays in our personal health.  Recently, a friend of a friend shared “My Parting Prescription for America” by the 19^th & 21^st Surgeon General of the United States, Dr. Vivek Murthy, and I am compelled to quote his opening section in full –

      “My father once told me that he never felt a sense of emptiness—that painful, gnawing sense that something is missing—until he left his village in India. It was a remarkable statement from a man who grew up with no running water or electricity, and whose family scarcely had enough money to put food on the table each night.

      Yet what they lacked in wealth, they made up for in community. Families looked out for each other. If you went by someone’s house, they invited you in to share whatever food they had. When my father lost his mother to tuberculosis when he was 10, the village stepped in to help my grandfather and his six children. Friends and extended family became surrogate parents.

      Against all odds, and bolstered by the support of his village, my father went on to study medicine. Medical school lectures and hospital rotations never taught him about the power of community. But his patients did, first in India and then later in the United States. Through their lives, he quickly came to see that community was a potent source of health and well-being. He observed that you could eat well, exercise, sleep eight hours a night, and have all the right vital signs, lab tests, and imaging studies.  But without community, it was hard to feel whole.

      My parents were grateful for the chance to make America their home, yet they missed that sense of community so much that they made sure to teach my sister and me about its importance as we grew up. Every time they visited a friend who lost a loved one or brought over food when someone was sick, they demonstrated to us the value of showing up for others. By surrounding our family with friends who never needed us to say or do anything special, they taught us the power of being around people who allow you to be unabashedly yourself.  And through their care for patients over the years—which involved everything from house calls to hospital visits to late-night phone conversations when someone fell ill—they reminded us that when we find our purpose in contributing to the lives of others, life isn’t always easy, but it is immensely gratifying.

      Over time, I came to appreciate that my parents weren’t teaching me how to build community—they were giving me the formula for fulfillment and well-being.

      Why? Because community is a powerful source of life satisfaction and life expectancy. It’s where we know each other, help each other, and find purpose in contributing to each other’s lives.

      These core pillars of community—relationships, service, and purpose—are powerful drivers of fulfillment.  They can also significantly influence health outcomes, including premature mortality, heart disease, depression, and anxiety. Community also gives us strength and resilience when facing the big challenges and countless paper cuts that come with moving through the world.

      We don’t have to be fulfilled in every way by one single community. Most of us need a few different communities in our lives to make us feel whole. And communities don’t have to be static; they can evolve and overlap, like when parents from our child’s school become part of our softball league or join our congregation.

      Some of the most enduring lessons about community can be found in faith and cultural traditions across the world. The teachings of Christianity ask us to love our neighbor as ourselves, and the Hindu scriptures guide us to care for our guests as we would care for the Divine. The Jewish emphasis on Hesed, loving-kindness, is a reminder of our obligation to be there for and care for each other, and the Muslim pillar of Zakat enshrines the importance of lifting up others through charity. The South African philosophy of Ubuntu—often translated as ‘I am, because we are’—emphasizes our interdependence and responsibility to one another as human beings.

      These are clear, consistent, and time-tested calls to cultivate community for our individual and collective well-being.”

I encourage you to read the full reflection, which was released on January 7, 2025.  As well, I invite you to hold me accountable.  One of my takeaways is to have lunch with each of my neighbors that lives on our street.  We fortunately have a friendly street, but time passes and we are all coming and going.  There are at least 21 men, so It should be a good exercise.  Please ask me this time next year if I accomplished this goal and how it went.

I hope 2025 is off to a good start for you and look forward to comparing notes when the opportunity allows.

Sources: 

Morningstar Research provided the portfolio analytics

Ned Davis Research

This letter is tonal in nature.  We use model portfolios and apply consistent thinking, but each client has a separate account and there are many reasons for exceptions, like tax basis, heirloom holdings, preferences, size of the account, etc. 

Data source for stock market proxies and representative portfolios: Morningstar Office.  Definitions for the metrics referenced can be found in the glossary toward the end of your Investment Plan Portfolio Summary.

Brightwater Advisory, LLC is an SEC registered investment adviser* with its principal place of business in Tampa, Florida.  This letter contains general information pertaining to our advisory services. The information is not suitable for everyone and should not be construed as personalized investment advice. This letter contains certain forward‐looking statements (which may be signaled by words such as “believe,” “expect” or “anticipate”) which indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward‐looking statements. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing involves risk, including risk of loss, which an investor must be prepared to bear.  We manage investments based upon factors which may include, but are not limited to, a client’s investment time horizon, income, net worth, attitude toward risk and investment knowledge. Therefore, it is important for clients to inform us promptly if there is a substantive change to his or her risk capacity, including financial situation. In addition, if goals and objectives have changed, please let us know immediately. Indices are unmanaged. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index.

For additional information about us, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site.

*Registration as an investment adviser does not imply any level of skill or training.

The post The 4%+ Bond Market – Opportunity or Risk? first appeared on Brightwater Advisory.

We sent the following note to clients on September 13th

Are Lower Interest Rates a Good Thing?

Seasons may be changing.  Sometimes we can detect the shift from one season to another, like maybe it is less hot in the early mornings and evenings.  Although it still feels like summer is in full swing, with the midday heat in Tampa at 90+ degrees and “feels like” readings of 103+, we know that climate conditions will change sooner than later.  The hope around my house is that we get a taste of fall by Halloween.

The economy, industries and markets have their own cyclicality as well, but they do not match to any particular timetable.  Sometimes these changes are noticeable, but most can only be identified in hindsight.  It is with some hesitation that I even dig in here.

We have an election bearing down on us and stock market price volatility picked up last month, but the catalyst for considering a seasonal change is that the Federal Reserve has recently signaled they will begin cutting interest rates as early as this month.  As well, the absolute level of the higher interest rate environment this year has presented an opportunity to adjust a balanced portfolio (stocks and bonds) more conservatively.

Reminder – owning stocks broadly over stretches of time has been a great opportunity, but they are a logically fickle asset class in the short term and exhibit normal behavior of a 10% sell off about once every year, 15% about every two years and over 20% about every 3.5 years (Ned Davis Research).  A posture of benign neglect is useful for ignoring the normal noise that comes along, but it is also useful to periodically reassess, especially when valuations change.

Two years and ten months ago the Federal Reserve signaled they would begin increasing interest rates.  The surprise was that they ended up increasing them much faster than expected.  The result has been an interest rate environment much higher than what prevailed on average over the prior 15 years.

We have perceived that change toward higher interest rates to be a net positive one, even if over-leveraged investors, businesses and consumers were likely to experience some stress.  2022’s declining stock and bond market was no fun for most anyone except an all-cash saver, but we think the ability for individuals and institutions to invest cash in risk free bonds/CDs for a reasonable interest rate again to be a good thing.

Historically interest rates have been much higher than the 0%-1% range they were held to since 2008 and with inflation popping up into the 5%+ range in 2021/2022, we also assumed the Federal Reserve understood the economy as being able to digest an interest rate at 3% or higher.  It has been bumpy in different areas getting here, but it seems like the domestic and global economies have managed to shift from the “zero-bound” and in some countries <0% interest rate world to a historically normal, positive interest rate world.  That is a sign of health and connects back to the logic of economic basics.

Otherwise, if the economy needed a near 0% interest rate to be okay, something was not okay.

We did not expect the interest rate rise to happen so quickly, but per past writings, we took advantage of that by reaping the benefit of patience with the bond allocation.  We had allowed maturities since the COVID panic of 2020 to roll over into short term treasury bills and money markets and began buying bonds again in 2022.  That process took about a year and then we extended the average maturity further in late 2023 and again earlier in 2024.  Our model portfolios* today hold an average of a four year maturity (some bonds come due this next year, while others in four to seven years) and a yield to maturity in the high 4% range (some are 4-ish% and some are 5-ish%).

So now what?

If higher interest rates have ultimately been okay for the economy, publicly traded companies and their stock prices, what does a lower interest rate foretell? 

Logically, lower interest rates will lower the cost of capital, which should eventually be a positive for corporate earnings, but is the Federal Reserve behind the curve again (pun intended for investing nerds – the interest rate curve is a reference to the relationship of a short term interest rate to a medium term one to a long term one) as they were in 2022? 

For example, the main reason why the 2022-2023 increase in rates was faster than expected is that inflation was coming in hotter than the Federal Reserve expected.  A reflexive process kicked off as they tried to play catch up via the “Fed Funds Rate” (a daily rate) compared to the swiftly rising 2-year treasury rate that kept moving higher in anticipation of the Fed raising rates to catch up. 

Is the new shift in policy to interest rate cuts something to be excited about or cautious about in the near term?  We cannot know for sure, but think it is reasonable to consider a change of seasons.  For example, different measures show the COVID liquidity injection to people’s checking accounts has run its course and maybe the higher rate environment has begun to “bite” with higher interest rates on credit cards (delinquencies highest in 20 years – St. Louis Fed), auto loans, home equity loans, etc as Chapter 11 bankruptcies are the highest in more than a decade (Cypress Capital, August 2024). 

Our assumption is that a methodical interest rate cut in a “soft landing” scenario would work out fine, but if the Federal Reserve needs to cut quicker and deeper than they have signaled, it would mean they are behind the curve again, which would imply soft revenue for businesses, declining profits or even losses, in the short term.

Stocks and Posture

Like the swift interest rate move, we did not expect stocks to recover their 2021 highs as quickly either, which they did toward the end of 2023.  However, these types of setbacks are allowed for and we held the equity allocation intact, as well as were able to do some net buying of stocks for most clients in 2022 (generally those not on planned distribution schedules) as part of our re-balancing process.

This year we have used the all time high in most stock indices as an opportunity to “over-balance.” “Re-balancing” is bringing allocations back into alignment by selling what has gone up to buy more of what has gone down or not gone up as much.  Over-balancing is selling a bit more and in this case we have been cutting the stock portion back to ~90% of target allocations or ~10% “under-weight” for most clients.

For example, if a portfolio has a target of 60% stocks we have sold enough to get to that 60%, but also an additional 6% (10% of 60%) and parked it in a treasury bill coming due on November 7th, 2024 and earning 5%+.

The opportunity cost is that stocks broadly keep working higher over the next year or so and a portfolio does not make as much as it could have, but the optionality is that if they retreat for any number of reasons, there is less capital at risk and we have an initial “portfolio budget” to work with to start buying stocks again to bring back into alignment.  I believe the optionality is worth the tradeoff.

Conclusion

Capital market conditions generally feel the same as they have been for a while where bad news doesn’t matter and any price breaks in stock indices are quickly covered over and forgotten.  A real outcome can be that the Federal Reserve may end up threading the needle for a soft economic landing, which would be a positive. 

The Federal Reserve will likely lower interest rates in the foreseeable future and the narrative around the stock market seems to be that lower interest rates are better.  But if the lower interest rate narrative shifts from being better to bad because of a lagged effect that higher rates are starting to bite, then stock market conditions likely become hostile.

Bottomline – stock prices are at all time highs, valuations are stretched on the over-valued side, earnings are okay but not great, dividend yields are near all time lows and cash is paying 5%, while five year risk free bonds still pay 3.6%.  I think cash and bonds both add a nice benefit to a liquid portfolio these days.  In the 14 years leading up to 2022, they were sources of stability in geo-political stress, but did not offer any interest to speak of.  They currently offer both interest and stability.

We are long term optimistic about the economy and stock prices and are not anchored on a change happening, but rather are focused on preparation, patience and flexibility.

*This letter is tonal in nature.  We use model portfolios and apply consistent thinking, but each client has a separate portfolio and there are many reasons for exceptions, like tax basis, planned distributions, heirloom holdings, preferences, size of the account, etc. 

Brightwater Advisory, LLC is an SEC registered investment adviser* with its principal place of business in Tampa, Florida.  This letter contains general information pertaining to our advisory services. The information is not suitable for everyone and should not be construed as personalized investment advice. This letter contains certain forward‐looking statements (which may be signaled by words such as “believe,” “expect” or “anticipate”) which indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward‐looking statements. There is no guarantee that the views and opinions expressed in this note will come to pass.

Investing involves risk, including risk of loss, which an investor must be prepared to bear.  We manage investments based upon factors which may include, but are not limited to, a client’s investment time horizon, income, net worth, attitude toward risk and investment knowledge. Therefore, it is important for clients to inform us promptly if there is a substantive change to his or her risk capacity, including financial situation. In addition, if goals and objectives have changed, please let us know immediately. Indices are unmanaged. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index.

For additional information about us, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site.

*Registration as an investment adviser does not imply any level of skill or training.

The post Are Lower Interest Rates a Good Thing? first appeared on Brightwater Advisory.

We sent the following letter to clients on January 25th.

Summary:

• Anecdotal Update – a story we can all learn from
• Landscape and shifting narratives – recession to “Goldilocks thinking”
• Portfolio approach – Barbell of risk free (stable income) and diversified growth (expected over time) – inflation and valuations

Anecdotal Update

I have had enough inquiries in my sharing with clients about my now 15-year-old son’s crypto mining venture that it is worth another update.  In short, it is still operational but barely has a pulse.  The “coin” he is mining was up substantially last year, but is still down 84% from its price two years ago when I originally shared the endeavor.  His “payback period” (time to break even on the initial investment) is now measured in years vs. months. 

The good news is he has given himself a ton of runway as he invested cash vs. credit and has no outside investors to deliver sad news to.

He bought two pieces of hardware for ~$400 each and his carry is electricity which is about like having a light bulb on all the time.  Mom and dad foot the electric bill.  His vision was to be “makin’ money” in his sleep or while he was at school, but the worst case is he loses his $800.  The best case is he has learned about risk and volatility (different), how to think about it and allow for it in his next endeavors.

Landscape and Narratives

Today, cash is paying 5%+, 5 year treasury bonds are 4.1%, 10 year treasury bonds are 4.1% and the SP 500 (large US stocks) is paying 1.4% dividends plus or minus the price changes.

Last year was the recession that never was and this year seems to be about a “soft landing,” economically, and “Goldilocks thinking” (which I will define shortly).  There should also be a focus on political “debates” during a fresh presidential election.

Corporate earnings came in “okay,” inflation’s increase slowed, the interest rate rise slowed and unemployment remained low.  The result was that bond prices stabilized and most stock indices generally recovered the ground they lost in 2022.

A recovering stock market has responded and added to the narrative of expecting a series of interest rate cuts from the Federal Reserve because they have mostly achieved one of their main objectives – the rate of inflation slowing from the 9% range to the 3% range.

One item that contributed to the recession narrative a year ago is a phenomenon called the “inverted yield curve,” which happens when short term interest rates are higher than long term interest rates.  The logic is both that the bond market is signaling economic weakness on the horizon or a Federal Reserve that is too tight or both. 

That phenomenon is still present today, as short term interest rates are ~5% and ten year interest rates are ~4%.  I think that relationship is still unsustainable.  It can be resolved by the Federal Reserve cutting interest rates  or longer term rates moving higher.  My bias in the meantime is that it is an economic drag.

Just like the consensus thinking a year ago about an imminent recession, who knows if the Federal Reserve will reverse course quickly.  I enjoy reading Howard Mark’s investor memos (Warren Buffett encouraged him to publish them years ago and they are a master class on the art of investing).  They are publicly available and his January piece references “Goldilocks thinking” as follows –

“At present, I believe the consensus is:

• • Inflation is moving in the right direction and will soon reach the Fed’s target of roughly 2%.
  • As a consequence, additional rate increases won’t be necessary.
  • As a further consequence, we’ll have a soft landing marked by a minor recession or none at all.
  • Thus, the Fed will be able to take rates back down.
  • This will be good for the economy and the stock market.

Marks continues –

… These five bullet points smack of ‘Goldilocks thinking’: the economy won’t be hot enough to raise inflation or cold enough to bring on an economic slowdown.  I’ve seen Goldilocks thinking in play a few times over the course of my career, and it rarely holds for long.  Something usually fails to operate as hoped, and the economy moves away from perception.  One important effect of Goldilocks thinking is that it creates high expectations among investors and thus room for potential disappointment (and losses).”

Economic environment

As I referenced in in my January 2022 letter, the environment likely shifted in November ’21 with the advent of the Fed tightening and my bias is that they will be measured in reversing course and unsympathetic to stock market tantrums in the meantime.  That view still resonates with me.  For example, the adjustments from the swift rise in interest rates from 2022 to present is likely still playing out as investors and companies are still coming to grips with a higher cost of capital. 

As the Fed raised their benchmark rate, we saw the almost simultaneous and rapid escalation in mortgage rates and home sales immediately plummeted.  Business borrowing also declined in light of higher rates but at a slower rate as the maturity dates of existing business loans are variable.  Unemployment has held strong below 4% and is probably the best example of a longer lag that has not been as variable as the Fed and the overall market would have predicted.  Could there be a larger increase in unemployment looming as the market continues to digest the higher interest rate environment?

Portfolio Approach in a conflicted environment

Our solution to investing within shifting winds is a continued focus on building portfolios around flexibility, robustness and value.  Specifically, we design portfolios with a risk-free ballast on one side (vs. risky, low quality bonds that appear to pay higher income) and a diversified risk approach for value and growth on the other. 

I am re-reading William Bernstein’s latest version of The Four Pillars of Investing:  Lessons for Building a Winning Portfolio, which was originally published in 2002 and is a classic.  This reminder about setting yourself up to follow through is worth highlighting –

“Happiness is a warm bond – [Bonds] are your lifeboat, your sleeping draught, and your option on the future… stick to short Treasuries, CDs, and munis…More important, how much of your investing discipline will survive a real market panic?  You won’t know the answers to those questions until this actually happens, but if your ‘cash’ is not of the highest quality, your discipline, and the magic of compounding along with it, will likely not survive.”

We think a lot about volatility and risk and about how to organize a client’s asset mixture.  We want to foster the ability (financially and as importantly, psychologically) to hang on during the down periods of stock market investing, which are very normal, but unpredictable, so that the benefits of compounding growth can work its magic over long stretches of time.

A basic premise is that I think people are wired optimistically but also have overconfidence of how they will behave during stress. 

COVID was a shocking test across the board of our lives, but I think the last two years has also been a good example that has taken longer to play out.  Part of composing my thoughts here is to help draw attention to the negatives of the world, so that we can allow for them and then get onto the optimistic part of growth, which the stock market has historically been able to do through a long list of caustic factors.

I think it is helpful to recognize that the market is a collection of the ownership of individual operating businesses that are attempting to create value in the world by offering goods and services that people need.  I think the average people running these businesses are intelligent and focused on value creation and by definition these operating companies attempt to adapt to a changing business environment. 

The inflationary environment of the 1970’s was very challenging for consumers, investors and businesses, but the US stock market (SP 500) grew its earnings 10.2% annually and dividends 6.5% annually during that time (NYU Stern School of Business).  Short term bonds are a grounding but they do not increase their interest organically like stocks do.  Owning a diversified mix of stocks has been a way to attach to profit and dividend streams that are a direct proxy for the expectation of prices to eventually or lurchingly recover after bouts of market stress.

Our stock investing continues to have an emphasis on areas that are considered fairly valued or undervalued vs. overvalued.  The stock portion of our model portfolio is more fairly valued  compared to a US stock index (S&P 500) and the global stock index – All Cap World Index (60% US stocks and 40% Int’l stocks) –

Though our model portfolio’s Long Term Earnings Growth expectation is slightly below the S&P 500 index, I view that as a relevant tradeoff for higher dividend yields and more favorably valued holdings.

_____________________________________________________________________________________________________________________________________

The information in this website blog (“blog”) is for informational purposes only and does not constitute a complete description of our investment services or performance. No part of this site nor the links contained therein is a solicitation or offer to sell securities or investment advisory services, except where applicable in states where we are registered, or where an exemption or exclusion from such registration exists. All investments involve risk of loss, including the possible loss of all amounts invested, and nothing within this blog should be construed as a guarantee of any specific outcome or profit. Past performance should not be construed as an indicator of future performance. Future performance may substantially differ from prior performance. This blog is confidential and is intended solely for the information of the person to whom it was delivered and may not be reproduced or redistributed in whole or in part.

This letter is tonal in nature.  We use model portfolios and apply consistent thinking, but each client has a separate account and there are many reasons for exceptions, like tax basis, heirloom holdings, preferences, size of the account, etc.  

Data source for stock market proxies and representative portfolios: Morningstar Office.  Definitions for the metrics referenced can be found in the glossary toward the end of your Investment Plan Portfolio Summary. 

Brightwater Advisory, LLC is an SEC registered investment adviser* with its principal place of business in Tampa, Florida.  This letter contains general information pertaining to our advisory services. The information is not suitable for everyone and should not be construed as personalized investment advice. This letter contains certain forward‐looking statements (which may be signaled by words such as “believe,” “expect” or “anticipate”) which indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward‐looking statements. There is no guarantee that the views and opinions expressed in this note will come to pass.

Investing involves risk, including risk of loss, which an investor must be prepared to bear.  We manage investments based upon factors which may include, but are not limited to, a client’s investment time horizon, income, net worth, attitude toward risk and investment knowledge. Therefore, it is important for clients to inform us promptly if there is a substantive change to his or her risk capacity, including financial situation. In addition, if goals and objectives have changed, please let us know immediately. Indices are unmanaged. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index.

For additional information about us, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site.

*Registration as an investment adviser does not imply any level of skill or training.

The post Higher Interest Rates Are A Good Thing – Part 2 first appeared on Brightwater Advisory.

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The information in this website blog (“blog”) is for informational purposes only and does not constitute a complete description of our investment services or performance.No part of this site nor the links contained therein is a solicitation or offer to sell securities or investment advisory services, except where applicable in states where we are registered, or where an exemption or exclusion from such registration exists. All investments involve risk of loss, including the possible loss of all amounts invested, and nothing within this blog should be construed as a guarantee of any specific outcome or profit. Past performance should not be construed as an indicator of future performance. Future performance may substantially differ from prior performance. This blog is confidential and is intended solely for the information of the person to whom it was delivered and may not be reproduced or redistributed in whole or in part.

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by Barry Brindise, Financial Planning Director

Yield to Maturity (YTM) and How to Think About Fixed Income Returns

At Brightwater Advisory, our process invests client resources in a diversified portfolio of assets.  Depending on each client’s needs, an investment plan will reflect an allocation between growth assets like stocks and exchange traded funds and fixed income instruments like bonds and CDs.  This summary focuses on the fixed income side of the portfolio and describes how investment returns for this asset class can be measured.

Fixed income investors are rewarded with a return on their investment (interest) that can take the form of periodic cash payments or a non-cash increase in-kind to the value of the underlying asset.  When we purchase a bond, it is important to understand the expected return which is referred to as a bond’s “Yield-To-Maturity,” commonly abbreviated as “YTM.”  Yield to maturity is the total return anticipated on a bond if the bond is held until it matures.  Yield to maturity is expressed as an annual rate so that we can compare bonds with different maturities.

For example, a 1-year CD with a “face value” at issuance (also called “par value”) of $1000 and an annual interest rate of 3% will make a cash interest payment at the end of the year equal to $30.00.  The investor receives this interest along with the par value of the CD, in this case $1000.  The math looks like the following: (($1030-$1000)) / $1000 = 3%.  In this example, calculating and understanding this CDs YTM is relatively straightforward.

However, not all fixed income securities are issued at par.  Treasury Bills (a type of bond with maturities of one year or less), are a common fixed income investment held in Brightwater accounts and are issued by the U.S. Government at a value below par, which is referred to as a “discount”.  For example, a one-year to mature U.S. Treasury bill with a face or par value of $1000 could be issued by the U.S. Treasury for $970.00.  In this example, no cash interest is paid for the entire year and then once the bond matures, the investor receives $1000 at the end of the year.  The anticipated yield to maturity for this treasury bill when originally sold is ($1000-$970) / ($970) = 3.1%.  Same math as our CD example above but a little less intuitive.

It is more complex to calculate the yield to maturity for a bond purchased at a discount to face value AND which makes cash coupon payments.  We therefore measure two components to understand the embedded rate of return or YTM.  To start, let’s say we have a Treasury Note (a longer duration U.S. government bond) par value $1000 with an annual coupon rate of 3.5% (these are paid semi-annually) and maturity of five years from now.  Since this note was ISSUED at par value of $1000 and since the coupon rate is 3.5%, then the YTM at the time of issue will also be 3.5%.  If market interest rates were to rise six months after this note was issued, then the trading price would likely decline to below par (another example of a price “discount”).  Then the current fair price would decline from $1000 to some amount, for example, $950 (the par value has not changed at $1000).  This discount is in response to market participants demanding the higher market rate of return.  The semi-annual coupon payment will be made as promised at the original coupon rate times the par value, $1000.  The yield to maturity for this note would be published by the custodian but we could also calculate it with a financial calculator.  In this example, due to the rising rate environment since it was originally issued, a new buyer of this bond would recognize a higher YTM of 4.1% so long as this bond was held to maturity.

The primary and simple rule to remember when it comes to bond pricing is that bond prices move INVERSELY to interest rates.  In other words, when interest rates rise, bond prices fall and when interest rates fall, bond prices will rise.  As a result, an investor cannot just look at a stated coupon rate to understand the rate of return they are earning.  As in our Treasury Note example above, the stated coupon on the asset was 3.5% but yield can be higher or lower than this amount depending on market forces.  Most importantly, the stated YTM at purchase is the rate of return an investor will receive regardless of what interest rates do in the meantime.  Back to our Treasury Note example, the investor who purchased the note at par value with a 3.5% coupon would receive the 3.5% YTM so long as they held the bond to maturity.  A new investor purchasing the same note at discount, when it has a new YTM of 4.1%, would receive the 4.1% rate of return so long as they held the bond to maturity.  There may be paper gains and losses in the meantime, but the return will be the stated YTM at the time the bond is purchased.    

Other considerations:  

Instead of a “discount”, some bonds will trade at “premiums,” which means their purchase price is above their par value.  For example, a bond with par value of $1000 could be trading at $1010 and higher.  You would still only receive $1000 at maturity.  Bond premiums were common during the lower interest rate environment that lasted up until the Fed recently began to raise rates to fight inflation.  Most federally guaranteed bonds yielded close to zero interest even though they were issued with coupon rates of 2% and higher.  The higher cost to purchase, the “premium,” effectively offset the coupon payments pushing these yields close to zero percent.

If you are interested in learning more, please feel free to contact Barry Brindise, Financial Planning Director, or David Maddux, CEO / CIO, at Brightwater Advisory.

Sources:  Kaplan – CFP Required Education. Investopedia (Bonds/Fixed Income)

The information in this website blog (“blog”) is for informational purposes only and does not constitute a complete description of our investment services or performance. No part of this site nor the links contained therein is a solicitation or offer to sell securities or investment advisory services, except where applicable in states where we are registered, or where an exemption or exclusion from such registration exists. All investments involve risk of loss, including the possible loss of all amounts invested, and nothing within this blog should be construed as a guarantee of any specific outcome or profit. Past performance should not be construed as an indicator of future performance. Future performance may substantially differ from prior performance. This blog is confidential and is intended solely for the information of the person to whom it was delivered and may not be reproduced or redistributed in whole or in part.

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