We are in unique economic times. By most accounts, the U.S. economy is rapidly recovering from the COVID-19-induced recession of 2020. But unlike other economic recoveries, there are few obvious investing opportunities.
The stock market and housing market are running red-hot, leading to fears of a correction or bubble. Interest rates are in the basement, meaning savings accounts, money market accounts, and bond yields are generally unexciting and might not even keep pace with inflation. Gold and crypto, both seen as stores of value, are volatile and already have relatively high valuations. And the prospect of increased inflation is looming, adding to all of this uncertainty.
The big question for anyone fortunate enough to have money to invest is where to put that money to work in 2021.
Unfortunately, it’s not an easy question to answer. We’ve never seen the confluence of stimulus packages, global supply chain disruptions, looming inflation, low interest rates, and increased consumer spending and confidence (among many other indicators) in a way that is similar to what we see today. We’re in new territory here.
But that doesn’t mean we’re flying blind. We can examine the data to the best of our ability and determine which asset classes are poised to deliver the best returns in the nascent economic recovery.
While it sounds boring, bond prices and yields (the interest rate paid on bonds) have broad implications for the entire economy, which is why we’ll start our analysis of asset classes here.
Bonds are generally seen as a low-risk asset class, particularly U.S. Treasuries, which are considered one of the safest investments in the world. Therefore, the demand for U.S. Treasuries is often used as a bellwether for investor sentiment about the economy as a whole.
When the economic outlook is poor, bond prices rise and yields fall as investors flock to the safety of bonds. When growth prospects are high, yields rise and prices drop, as bonds are forced to compete with alternative asset classes for investment dollars.
Over the last several decades, bond yields have been on the decline, the reasons for which go beyond the scope of this article. But suffice to say, they are historically very low.
As you can see from the tail end of this chart, yields reached their lowest point on record over the summer of 2020. But at the beginning of 2021, bond yields started to rise again on economic growth expectations due to the ongoing recovery.
But then came inflation risk, which can hamper the bond market in two ways.
First, inflation reduces the value of the payments paid on a bond. So, while the dollar amount of the payments will stay the same, the purchasing power of those bond payments will decline. This decreased value can lead investors to move their money away from bonds.
Second, the Fed could raise interest rates to tamp down inflation. If this happens, yields will climb, lowering the price investors could fetch for their current bond holdings.
As of this writing, yields sit at around 1.63%—a big increase from where things were last summer, when yields sat around 0.6%.
If you’re holding a bond that earns 1.63% and the government targets 2% inflation, then you’re planning to lose money when adjusted for inflation (unless yields fall again and you can sell the bond for profit, but that’s unlikely to happen). In an inflationary environment, these types of bond yields are not too exciting.
Bottom line: Bond yields have moved up for the first time, which can seem enticing. But bonds, at least in terms of 10-year U.S. Treasuries, are still unlikely to outpace inflation. Riskier corporate or municipal bonds could offer better returns.
It’s no secret that the stock market has outperformed expectations during the last year. Following a drop of about 30% across most indices in March of 2020, the markets boomed for the remainder of 2020. As of this writing, the S&P 500 grew around 60% from its bottom in March 2020 to May 2021.
But can this continue? Like everything right now, it’s hard to say. In just the past few weeks, the market has been increasingly volatile as it reacts to news elsewhere in the economy. Whether the market will continue to grow or face a correction is yet to be seen. There are rational arguments on both sides.
There are a few factors that may point to continued stock market growth.
- With GDP forecast to grow 6.4% in 2021, corporate earnings are likely to grow as well, taking stock prices with them.
- Despite bond yields rising at the beginning of 2021, they have begun to flatten. Low bond yields are generally considered good for the stock market because the paltry returns offered by bonds won’t entice investment dollars away from the stock market.
- The stock market has been on fire, and with no other asset classes providing obvious alternatives, momentum may keep driving things up. Investors may deem the risks of investing in a hot market worth the potentially outsized reward.
On the other hand, the stock market does have risks.
- The prospect of inflation can hurt certain stocks, particularly dividend stocks (because the value of the dividend payment decreases) and growth stocks that rely on cheap debt to fuel growth. With recent inflation measures trending higher and subsequent fears of interest rate hikes, we’ve already seen some of the high-flying stocks from last year decline.
- Valuations are very high. One of the most reliable measures of the total market value is its price-to-earnings ratio, which measures a company’s share price against that company’s earning (P/E ratio). This chart shows the aggregate P/E ratio of the S&P 500. Except for the Dot Com boom in the late ’90s, P/E ratios near or above 30 are rarely sustained. We’re approaching 40.
Overall, more experienced stock market forecasters than I are forecasting a bull market in 2021, but with a lot of volatility.
In his February forecast, Andrew Slimmon of Morgan Stanley wrote, “Based on history, investors should hold tight and keep eyes on the longer term. The second year of a new bull market historically performs quite well overall, though it tends to be more gut-wrenching along the way.”
Bottom line: The stock market is trading at very high valuations, meaning there is an increased risk of a correction. Yet with little competition from other asset classes, GDP growth, and low interest rates, the market could continue to grow.
Cash investments (savings accounts, money market accounts, CDs, etc.) are low-risk, low-return investments. You can still put your money in the bank and have a very high probability of receiving the interest promised.
The problem with cash investments is that they have offered rock-bottom returns over the last decade or so, and that is unlikely to change anytime soon.
The interest earned on cash investments is based on the Effective Federal Funds Rate, which is so low you can’t even see it on the chart above.
The government lowered interest rates dramatically following the financial crisis to stimulate economic recovery. The result is that the interest you can earn on cash investments declined to near zero. Savings accounts and CDs have offered very little over the past decade.
With the economy in great shape prior to COVID-19, the Fed began raising rates gradually around 2015. But, with the 2020 recession, rates were dropped back down to near zero and are still there today.
The Fed has stated that they intend to keep interest rates low for the foreseeable future to assist with the economic recovery. The only thing that could change the Fed’s strategy is if inflation starts to get uncomfortably high for a sustained period, in which case interest rates could rise again.
But to be clear, better rates on cash investments due to inflation are not a good thing. Inflation means that your money will be worth less in the future, so even if you get a better rate on a money market account, it will be offset by inflation.
The current interest you can earn on a money market account is about 0.5%. That is unlikely to even keep pace with inflation, which the government wants to hit at least 2%. Some indicators show it could be higher, at least in the next few months.
Of course, one reason to hold cash is that you believe that other asset classes will tank. This strategy would allow one to buy into those depreciated assets at lower prices. In this uncertain economy, it could make sense to hold onto more cash than usual. If those crashes don’t happen, though, there is an opportunity cost in holding cash when other asset classes are growing.
Bottom line: With interest rates near zero and inflation indicators rising, cash investments are safe but offer little return (or even negative returns when adjusted for inflation). Cash investments really only make sense if you feel the stock and/or housing markets will crash in the short term.
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Cryptocurrency has absolutely exploded in the last year, both in terms of valuations and market cap. According to CoinMarketCap, Bitcoin’s market cap is just about $750 billion (though the crypto market is tanking as I write this). Meaning that if Bitcoin were a company, it would be the eighth-largest company in the world—just beating out Warren Buffet’s Berkshire Hathaway.
And that’s just Bitcoin. Check out this chart that shows the total market capitalization of cryptocurrencies. Note that the scale of the scale is in trillions of dollars. There’s a lot of money flowing into the crypto market.
Personally, I think crypto will stick around and become something even bigger than it is today. I even have some modest investments in a few different currencies. But I fully recognize that crypto, right now, is highly speculative, and the path to consistent or predictable returns is unclear. I know I could still lose it all.
What points to longer-term growth in crypto is that interest in investing seems to be growing rapidly. A recent survey by crypto exchange Gemini points to the fact that 63% of those surveyed are curious about investing in crypto, versus only 23% who are disinterested. Another interesting finding is that the number of people intending to invest in crypto is set to double in the next 12 months.
So, while many trends point to crypto being here to stay, it remains unclear who wins, who loses, and what the forecast for the broader crypto market is for the next year or so. At this stage, unless you’re a straight-up riverboat gambler and want to go all-in, I think modest holdings in the crypto market make sense, but only for those who are comfortable with a lot of risk.
Bottom line: Your guess is as good as mine. Want to roll the dice?
Gold has, for centuries, been considered a strong store of value—basically an asset to plant some money in because it holds its value pretty well. For this reason, investors have often flocked to gold during periods of uncertainty.
Throughout the centuries, governments, nations, and their respective currencies have risen and fallen. But through it all, gold has pretty much always held up as a store of value and has provided a good inflation hedge.
While there is some debate about how well gold still hedges inflation, it has worked in the past. When inflation hits, gold prices tend to increase—but not always at the same inflation rate.
I would definitely consider right now a period of uncertainty, so there appears to be a renewed interest in gold. A friend of mine recently went so far as to buy some physical gold, which is cool, but physical gold is different from what I’m talking about here. Rather, I’m talking about investing in gold through an ETF like GLD. Check out the price of SPDR Gold Shares (GLD) from Yahoo! Finance.
As you can see from the chart from Yahoo!, gold prices have been up for the last several years, and after declines in 2020, prices are currently rebounding. But I chose this zoomed-out view of gold’s performance to show that gold performed far worse than the stock market during the most recent economic expansion.
During gold’s down years between 2013 and 2018, the stock market was delivering double-digit returns year in and year out. There is a price to pay by overweighing your assets towards gold during economic expansions, even though it has inflation-hedging value.
My guess is that while we wait and see the extent of inflation in our future, gold prices will trend upwards, but with some volatility.
Bottom line: Gold is a solid hedge against inflation and a relatively low-risk addition to a well-diversified portfolio.
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Last, but certainly not least, we have real estate investing.
As with the rest of the economy, the real estate market is experiencing unprecedented conditions. Extremely low supply, growing demand, and extremely low interest rates have sent property values skyrocketing. Double-digit appreciation rates have become the norm in many cities.
This makes for an interesting conundrum for real estate investors. Similar to the situation with the stock market, should you buy into an already hot market?
I am planning to, and I’ll tell you why.
Hedging against inflation
These properties actually provide four separate hedges all at once.
- When prices in general rise, so will rent. This means rental property investors’ income keeps pace with expense increases.
- Property prices generally appreciate at least as fast as inflation, if not faster. This is another great hedge.
- The greatest part of owning a rental property is you can finance it with debt. Right now, you can get a mortgage at one of the lowest rates in history and hold on to that for 30 years. Meaning that while property and rent prices go up due to inflation, your mortgage payment stays the same. Your income and asset value keep pace with inflation while your expenses remain low–that’s amazing.
- The amortization on your loan can hedge inflation by itself. According to a recent analysis I ran on a $200,000 loan with a 4% interest rate, you can earn a compound annual growth rate of 4.5-5% on a rental property by just making your mortgage payments on time. No appreciation, no cash flow, just paying your mortgage (with rental income). Even with inflation trending upwards, amortization alone should keep pace with inflation.
|Year||Total interest paid||Total principal paid||Total principal remaining||Principal per year||Amortization return||CAGR|
Personally, I believe that appreciation is going to continue, at least through 2021. I’ve written and talked about this extensively elsewhere, but the combination of low supply, high demand, and low interest rates would need to change dramatically to cause prices to decline.
If any of these factors were to change significantly, I think it would be interest rates rising rapidly due to inflation. Personally, I don’t see that happening anytime soon, as the Fed has indicated they will keep rates low unless they see uncomfortably high inflation for several months in a row. Even if that happens, the Fed will likely raise rates very gradually.
With an expanding economy, and favorable generational demographics (the large millennial generation is entering peak home-buying years), I don’t see demand decreasing.
In terms of inventory, housing starts have been disappointing, meaning that the housing shortage in the U.S. is here to stay—at least for the next year or so. Yes, existing home sales will start to recover, but I don’t see that causing a crash in the market, likely just a cooling back to more normal levels of price growth. Lastly, the number of homes in forbearance is steadily declining, leading to less risk of a foreclosure crisis and flood of new inventory on the market.
I don’t personally see a decline in property prices in 2021, but even if they do decline, the worst-case scenario isn’t that bad. If you bought a property in Q1 of 2007—right before the biggest decline in U.S. home prices since HUD started tracking—you would still come out on top.
The growth of the median home price between 2007 and today averaged 2.4% annually. Inflation, on the other hand, averaged 1.85% annually. Meaning that even people who bought at the worst possible time still produced a positive (albeit small) return on their investment, even when adjusted for inflation.
And that’s just from appreciation. If you factor cash flow and amortization in over those 14 years, those investors likely got a solid return.
As I said before, amortization alone should provide a 4-5% CAGR on your investment. So even if prices temporarily decrease and you only break even in terms of cash flow, you’re still likely to outpace inflation by several percentage points.
Don’t get me wrong, investing in real estate today does carry more risk than we’ve seen in about a decade. Investing in this market makes it more important than ever to find a good deal. Don’t get caught up in the hysteria and make a bad decision just to buy something.
If you’re investing for the long run and have enough liquidity to weather tough times, rental property investing always pays off. In my opinion, the risk of significant losses in real estate is less than in other asset classes if you’re playing the long game. I don’t think this crazy high market changes that, even if cash flow isn’t that great right now.
The recovery from the COVID-19 crisis has created a unique and confusing economic landscape. There are few obvious investment opportunities, and each investor needs to develop a hypothesis for themselves to navigate this uncertain time.
For me, I am going to continue doing what I have done for a decade. I maintain investments across every investment class mentioned here: bonds, stock, cash, crypto, gold, and, of course, real estate. I have not invested in any properties over the last year but am actively looking at a few turnkey properties in the Southeast and plan to buy one or two in 2021.
While buying into a hot market does come with additional risk and uncertainty, I firmly believe that real estate investing is the strongest hedge against inflation to mitigate short-term risk and still offers that same long-term upside that it always has. Just play the long game. Even if I don’t get incredible returns in the next few years, to me, it’s still the best option out there.