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SMART INSIGHTS FROM PROFESSIONAL ADVISERS

Why I'm Growing Cautious About the Markets

With interest rates stuck in low gear, consider holding more bonds, cash and alternative investments.

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In Nobel Laureate Robert Shiller's seminal book, Irrational Exuberance, the Yale economics professor describes how the capital markets tend to move in feedback loops, sometimes positive and sometimes negative. He looks at periods in which market "bubbles" have formed and ultimately popped, such as the sub-prime housing market in 2008, the dot-com bubble of the late 1990s, going all the way back to the famous Holland tulip mania of the 17th century.

See Also: 5 Best Bond Funds to Buy While the Fed Keeps Rates Down

What's most interesting about these boom-and-busts is that they often collapse based on information widely known throughout most of the bubble formation. What shifts is investor sentiment about that information, triggering a move from a positive feedback loop to a negative one. The challenge is predicting when that shift will occur.

Today, I would argue, we are experiencing the shift from a positive feedback loop to a negative one. For the past seven years or so, good economic news has been perceived as positive because it signaled a strengthening economy following the 2008 market meltdown. Similarly, economic news that could be perceived as "bad"—sluggish growth prompting central banks around the world to inject stimulus into the markets, for example—has been perceived as a positive.

In recent months, things have changed. With the Federal Reserve trying to normalize monetary policy (see How the Fed Works), most economists forecasted at the beginning of the year that we would see four interest rate hikes in the United States. With nearly half the year gone, those same economists are predicting just one interest rate hike in 2016.

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The fear is that our economy has become addicted to low interest rates and any increases may cause a disruption to an already tepid recovery. With corporate earnings slowing and many economists arguing we are near full employment, the Fed's next move may be a rate cut rather than a rate hike.

The Behavioral Effects of Negative Rates

In another best-selling book with "irrational" in the title, Predictably Irrational, famed behavioral psychologist Amos Tversky analyzes the power of "free." In one experiment, he watches as a significantly larger number of people accept a free Hershey's Kiss rather than a Kiss that costs a penny. While a one-cent difference at any other price point does not affect behavior, the move from one cent to free triggers a different response. Accepting something for free, particularly something with a known value (such as a Hershey's Kiss), is a different type of transaction. It's one-sided (you receiving something) and appears to carry no risk since you are not parting with anything.

What would happen if we extended Tversky's experiment one step further? What if someone said, "I will pay you to take one of these Hershey Kisses?" For some, that would certainly raise red flags. You might wonder, "What could be wrong with the chocolate that this person has to pay people to take it?"

We can apply the same logic to the global credit markets. Interest rates are the cost of borrowing money (think auto loans, mortgages, student loans, etc.). Low interest rates are great. Zero interest rates (free money) are even better. But what if lenders offer to pay you to take out a loan? Suspicion is sure to creep into the minds of at least some borrowers and may encourage the wrong types of people to seek credit (i.e. adverse selection).

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This is precisely the situation we find ourselves in today. In an effort to stimulate their economies and create inflation, central banks around the world are pushing interest rates down. Recently, the interest rates on the German 10-year bond (known as the Bund) and the Swiss 30-year bond fell into negative territory. As economics-textbook publishers scramble to add a chapter on negative interest rates, investors are left to guess what the impact will be.

What Can You Do?

One thing is certain: Low interest rates hurt savers and retirees. As they hunt for yield, investors are taking on more risk. We are advising clients to adjust their expectations about rates of return and to look at alternative investments such as Business Development Corporations (BDCs) or Real Estate Investment Trusts (REITs) to supplement their stock and bond allocations.

We also have higher than normal cash positions in our discretionary accounts and are focused on protecting against downside risk. As I have written previously, in this environment, we believe that investment-grade corporate bonds and municipal bonds that can be held to maturity present the most compelling risk-reward profile for retirement income.

See Also: Kiplinger's Economic Outlook on Interest Rates

DISCLOSURE STATEMENT: "Investing in alternative investments may not be suitable for all investors and involves special risks, such as risk associated with leveraging the investment, adverse market forces, regulatory changes, and illiquidity. There is no assurance that the investment objective will be attained."

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"Corporate bonds contain elements of both interest rate risk and credit risk. The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income."

"Municipal bonds are federally tax-free but may be subject to state and local taxes, and interest income may be subject to federal alternative minimum tax (AMT). The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income."

Bryan Koslow, MBA, CFP®, CPA, PFS, CDFA™ is the President of Clarus Financial Inc., an Integrated Wealth Management firm with offices in NYC & NJ.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff.