Retirees have noticed that the stock market performance seems to be disconnected from the underlying economy. What continues to drive the stock market indices to all-time highs when many of the underlying stocks themselves aren’t? The results of a recent survey of Central Banks may provide the answer. For the first time in history, multiple countries have begun to invest their ‘reserves’ into equities; specifically exchange-traded funds (Bloomberg).

Why are central banks beginning to invest in the stock market? For the same reason that many retirees find themselves doing so (or considering  to do so). Low interest rates are ‘encouraging’ central banks to contemplate asset classes that previously were considered far too risky. With inflation gaining ground, they have the same battle that retired investors do—how to protect the purchasing power of their portfolio. “Seventy percent of central bank reserve managers said they preferred A-grade government bonds this year. Twenty percent said they like junk-rated government and corporate bonds” (FoxNews)

One reserve manager explained that yield compression has led to a search for yields in different asset classes. The non-traditional asset classes include foreign currencies and exchange traded funds. The report states that “the Swiss National Bank has allocated about 12% of assets to passive funds tracking equity indexes.” In fact, almost ¼ of all central banks admit to owning shares of equities or that they plan to buy them.

What Impact Does This Have On Retirees?

First, the influx of central bank monies into the stock market indexes creates a disconnect between the performance of the indexes relative to the underlying stocks. Said differently, the performance of the market indexes is not the result of a broad-based rally; the rising tide is not lifting all boats. Accordingly, retirees might consider allocating a larger part of their equity monies to index-related exchange-traded funds as opposed to individual stocks.

Second, central banks investing in equities will inevitably result (in my opinion) even greater levels of volatility and thus increase the potential loss to retirees who have also diversified into stocks in search of higher returns. What will traditionally conservative central bank reserve managers do when we see a typical stock market correct of 10% to 20%? How much loss will they endure before they are forced to take action to protect their country’s monetary reserves? Pulling those funds out of the stock market (unless done slowly over an extended period of time) will inevitably cause the markets to go down. The decline of the markets can then trigger other trading algorithms to sell and a plunge of several percent is likely. Selling begets selling and adding another group of large players will increase the risk to the retired investor. That means that the strategies and methods a retired investor uses to determine when to buy and when to sell takes on greater importance. These are not markets where retired investors should trust their life’s savings to the traditional buy and hold strategy.

Third, there may be long-term implications that result in the decline of the USD. Currently, the US stock market is one of the best performing in the world so it is reasonable to assume that a large portion of those central bank reserves that are invested in equities have been invested in US markets. That supports the strength of the USD. Global investors, wary of the safety of investments in their own countries (think Cyprus and Japan) are also moving money to the U.S. The survey also indicated that $1.26 trillion of central bank reserves have been invested in China’s remninbi. Over 25% of the respondents representing another $1.3 trillion said they were “considering investing in China’s currency now.” So although the current flow of monies is supporting the value of the U.S. dollar, the diversification of central bank reserves has the potential to exacerbate the decline of the U.S. dollar. Retired investors might consider diversifying their currency exposure now by investing in stocks on non-US exchanges and/or foreign currencies. For instance, I currently hold Canadian positions in my client accounts and may be adding Australian ones in the future.

So retired investors have been correct in their view that the performance of the stock market indexes doesn’t seem correlated to the performance of our underlying economy and the news that central banks have been buying index-related exchange traded funds supports that theory. The entrance of central banks into the equity markets may result in the stock market continuing to climb but it will also increase volatility and thus make it more risky for conservative, retired investors.