Posts filed under ‘Fixed Income (Bonds)’

The Only Thing to Fear is the Unknown Itself

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Martin Luther King, Jr. famously stated, “The only thing we have to fear is fear itself,” but when it comes to the stock market, the only thing to fear is the “unknown.” As much as people like to say, “I saw that crisis coming,” or “I knew the bubble was going to burst,” the reality is these assertions are often embellished, overstated, and/or misplaced.

How many people saw these events coming?

  • 1987 – Black Monday
  • Iraqi War
  • Thai Baht Currency Crisis
  • Long-Term Capital Management Collapse & Bailout
  • 9/11 Terrorist Attack
  • Lehman Brothers Bankruptcy / Bear Stearns Bailout
  • Flash Crash
  • U.S. Debt Downgrade
  • Arab Spring
  • Sequestration Cuts
  • Cyprus Financial Crisis
  • Federal Reserve (QE1, QE2, QE3, Operation Twist, etc.)

Sure, there will always be a prescient few who may actually get it right and profit from their crystal balls, but to assume you are smart enough to predict these events with any consistent accuracy is likely reckless. Even for the smartest and brightest minds, uncertainty and doubt surrounding such mega-events leads to inaction or paralysis. If profiting in advance of these negative outcomes was so easy, you probably would be basking in the sun on your personal private island…and not reading this article.

Coming to grips with the existence of a never-ending series of future negative financial shocks is the price of doing business in the stock market, if you want to become a successful long-term investor. The fact of the matter is with 7 billion people living on a planet orbiting the sun at 67,000 mph, the law of large numbers tells us there will be many unpredictable events caused either by pure chance or poor human decisions. As the great financial crisis of 2008-2009 proved, there will always be populations of stupid or ignorant people who will purposely or inadvertently cause significant damage to economies around the world.

Fortunately, the power of democracy (see Spreading the Seeds of Democracy) and the benefits of capitalism have dramatically increased the standards of living for hundreds of millions of people. Despite horrific outcomes and unthinkable atrocities perpetrated throughout history, global GDP and living standards continue to positively march forward and upward. For example, consider in my limited lifespan, I have seen the introduction of VCRs, microwave ovens, mobile phones, and the internet, while experiencing amazing milestones like the eradication of smallpox, the sequencing of the human genome, and landing space exploration vehicles on Mars, among many other unimaginable achievements.

Despite amazing advancements, many investors are paralyzed into inaction out of fear of a harmful outcome. If I received a penny for every negative prediction I read or heard about over my 20+ years of investing, I would be happily retired. The stock market is never immune from adverse events, but chances are a geopolitical war in Ukraine/Iraq; accelerated Federal Reserve rate tightening; China real estate bubble; Argentinian debt default; or other current, worrisome headline is unlikely to be the cause of the next -20%+ bear market. History shows us that fear of the unknown is more rational than the fear of the known. If you can’t come to grips with fear itself, I fear your long-term results will lead to a scary retirement.

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

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June 21, 2014 at 1:13 pm 3 comments

Stocks Winning vs. Weak Competitors

 

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This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (June 2, 2014). Subscribe on the right side of the page for the complete text.

Winning at any sport is lot easier if you can compete without an opponent. Imagine an NBA basketball MVP LeBron James driving to the basket against no defender, or versus a weakling opponent like a 44-year-old investment manager. Under these circumstances, it would be pretty easy for James and his team, the Miami Heat, to victoriously dominate without even a trace of sweat.

Effectively, stocks have enjoyed similar domination in recent years, while steamrolling over the bond competition. To put the stock market’s winning streak into perspective, the S&P 500 index set a new all-time record high in May, with the S&P 500 advancing +2.1% to 1924 for the month, bringing the 2013-2014 total return to about +38%. Not too shabby results over 17 months, if you consider bank deposits and CDs are paying a paltry 0.0-1.0% annually, and investors are gobbling up bonds yielding a measly 2.5% (see chart below).

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The point, once again, is that even if you are a skeptic or bear on the outlook for stocks, the stock market still offers the most attractive opportunities relative to other asset classes and investment options, including bonds. It’s true, the low hanging fruit in stocks has been picked, and portfolios can become too equity-heavy, but even retirees should have some exposure to equities.

As I wrote last month in Buy in May and Dance Away, why would investors voluntarily lock in inadequate yields at generational lows when the earnings yield on stocks are so much more appealing. The approximate P/E (Price-Earnings) ratio for the S&P 500 currently averages approximately +6.2% with a rising dividend yield of about +1.8% – not much lower than many bonds. Over the last five years, those investors willing to part ways with yield-less cash have voted aggressively with their wallets. Those with confidence in the equity markets have benefited massively from the approximate +200% gains garnered from the March 2009 S&P 500 index lows.

For the many who have painfully missed the mother of all stock rallies, the fallback response has been, “Well, sure the market has tripled, but it’s only because of unprecedented printing of money at the QE (Quantitative Easing) printing presses!” This argument has become increasingly difficult to defend ever since the Federal Reserve announced the initiation of the reduction in bond buying (a.k.a., “tapering”) six months ago (December 18th). Over that time period, the Dow Jones Industrial Average has increased over 800 points and the S&P 500 index has risen a healthy 8.0%.

As much as everyone would like to blame (give credit to) the Fed for the bull market, the fact is the Federal Reserve doesn’t control the world’s interest rates. Sure, the Fed has an influence on global interest rates, but countries like Japan may have something to do with their own 0.57% 10-year government bond yield. For example, the economic/political policies and demographics in play might be impacting Japan’s stock market (Nikkei), which has plummeted about -62% over the last 25 years (about 39,000 to 15,000). Almost as shocking as the lowly rates in Japan and the U.S. and Japan, are the astonishingly low interest rates in Europe. As the chart below shows, France and Germany have sub-2% 10-year government bond yields (1.76% and 1.36%, respectively) and even economic basket case countries like Italy and Spain have seen their yields pierce below the 3% level.

63Source: Dr. Ed’s Blog

Suffice it to say, yield is not only difficult to find on our shores, but it is also challenging to find winning bond returns globally.

Well if low interest rates and the Federal Reserve aren’t the only reasons for a skyrocketing stock market, then how come this juggernaut performance has such long legs? The largest reason in my mind boils down to two words…record profits. Readers of mine know I follow the basic tenet that stock prices follow earnings over the long-term. Interest rates and Fed Policy will provide headwinds and tailwinds over different timeframes, but ultimately the almighty direction of profits determines long-run stock performance. You don’t have to be a brain surgeon or rocket scientist to appreciate this correlation. Scott Grannis (Calafia Beach Pundit) has beautifully documented this relationship in the chart below.

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Supporting this concept, profits help support numerous value-enhancing shareholder activities we have seen on the rise over the last five years, which include rising dividends, share buybacks, and M&A (Mergers & Acquisitions) activity. Eventually the business cycle will run its course, and during the next recession, profits and stock prices will be expected to decline. A final contributing factor to the duration of this bull market is the abysmally slow pace of this economic recovery, which if measured in job creation terms has been the slowest since World War II. Said differently, the slower a recovery develops, the longer the recovery will last. Bill McBride at Calculated Risk captured this theme in the following chart:

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Despite the massive gains and new records set, skeptics abound as evidenced by the nearly -$10 billion of withdrawn money out of U.S. stock funds over the last month (most recent data).

I’ve been labeled a perma-bull by some, but over my 20+ years of investing experience I understand the importance of defensive positioning along with the benefits of shorting expensive, leveraged stocks during bear markets, like the ones in 2000-2001 and 2008-2009. When will I reverse my views and become bearish (negative) on stocks? Here are a few factors I’m tracking:

  • Inverted Yield Curve: This was a good precursor to the 2008-2009 crash, but there are no signs of this occurring yet.
  • Overheated Fund Inflows: When everyone piles into stocks, I get nervous. In the last four weeks of domestic ICI fund flow data, we have seen the opposite…about -$9.5 billion outflows from stock funds.
  • Peak Employment: When things can’t get much better is the time to become more worried. There is still plenty of room for improvement, especially if you consider the stunningly low employment participation rate.
  • Fed Tightening / Rising Bond Yields: The Fed has made it clear, it will be a while before this will occur.
  • When Housing Approaches Record Levels: Although Case-Shiller data has shown housing prices bouncing from the bottom, it’s clear that new home sales have stalled and have plenty of head room to go higher.
  • Financial Crisis: Chances of experiencing another financial crisis of a generation is slim, but many people have fresh nightmares from the 2008-2009 financial crisis. It’s not every day that a 158 year-old institution (Lehman Brothers) or 85 year-old investment bank (Bear Stearns) disappear, but if the dominoes start falling again, then I guess it’s OK to become anxious again.
  • Better Opportunities: The beauty about my practice at Sidoxia is that we can invest anywhere. So if we find more attractive opportunities in emerging market debt, convertible bonds, floating rate notes, private equity, or other asset classes, we have no allegiances and will sell stocks.

Every recession and bear market is different, and although the skies may be blue in the stock market now, clouds and gray skies are never too far away. Even with record prices, many fears remain, including the following:

  • Ukraine: There is always geopolitical instability somewhere on the globe. In the past investors were worried about Egypt, Iran, and Syria, but for now, some uncertainty has been created around Ukraine.
  • Weak GDP: Gross Domestic Product was revised lower to -1% during the first quarter, in large part due to an abnormally cold winter in many parts of the country. However, many economists are already talking about the possibility of a 3%+ rebound in the second quarter as weather improves.
  • Low Volatility: The so-called “Fear Gauge” is near record low levels (VIX index), implying a reckless complacency among investors. While this is a measure I track, it is more confined to speculative traders compared to retail investors. In other words, my grandma isn’t buying put option insurance on the Nasdaq 100 index to protect her portfolio against the ramifications of the Thailand government military coup.
  • Inflation/Deflation: Regardless of whether stocks are near a record top or bottom, financial media outlets in need of a topic can always fall back on the fear of inflation or deflation. Currently inflation remains in check. The Fed’s primary measure of inflation, the Core PCE, recently inched up +0.2% month-to-month, in line with forecasts.
  • Fed Policy: When are investors not worried about the Federal Reserve’s next step? Like inflation, we’ll be hearing about this concern until we permanently enter our grave.

In the sport of stocks and investing, winning is never easy. However, with the global trend of declining interest rates and the scarcity of yields from bonds and other safe investments (cash/money market/CDs), it should come as no surprise to anyone that the winning streak in stocks is tied to the lack of competing investment alternatives. Based on the current dynamics in the market, if LeBron James is a stock, and I’m forced to guard him as a 10-year Treasury bond, I think I’ll just throw in the towel and go to Wall Street. At least that way my long-term portfolio has a chance of winning by placing a portion of my bets on stocks over bonds.

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

June 2, 2014 at 11:06 am Leave a comment

Confessions of a Bond Hater

Source: stock.xchng

Source: stock.xchng

Hi my name is Wade, and I’m a bond hater. Generally, the first step in addressing any type of personal problem is admitting you actually have a problem. While I am not proud of being a bond hater, I have been called many worse things during my life. But as we have learned from the George Zimmerman / Trayvon Martin case, not every situation is clear-cut, whether we are talking about social issues or bond investing. For starters, let me be clear to everyone, including all my detractors, that I do not hate all bonds. In fact, my Sidoxia clients own many types of fixed income securities. What I do hate however are low yielding, long duration bonds.

Duration…huh? Most people understand what “low yielding” means, when it comes to bonds (i.e., low interest, low coupon, low return, etc.), but when the word duration is uttered, the conversation is usually accompanied by a blank stare. The word “duration” may sound like a fancy word, but in reality it is a fairly simple concept. Essentially, high-duration bonds are those fixed income securities with the highest sensitivity to changes in interest rates, meaning these bonds will go down most in price as interest rates rise.

When it comes to equity markets, many investors understand the concept of high beta stocks, which can be used to further explain duration. There are many complicated definitions for beta, but the basic principle explains why high-beta stock prices generally go up the most during bull markets, and go down the most during bear markets. In plain terms, high beta equals high octane.

If we switch the subject back to bonds, long duration equals high octane too. Or stated differently, long duration bond prices generally go down the most during bear markets and go up the most during bull markets. For years, grasping the risk of a bond bear market caused by rising rates has been difficult for many investors to comprehend, especially after witnessing a three-decade long Federal Funds tailwind taking the rates from about 20% to about 0% (see Fed Fatigue Setting In). 

The recent interest rate spike that coincided with the Federal Reserve’s Ben Bernanke’s comments on QE3 bond purchase tapering has caught the attention of bond addicts. Nobody knows for certain whether this short-term bond price decline is the start of an extended bear market in bonds, but mathematics would dictate that there is only really one direction for interest rates to go…and that is up. It is true that rates could remain low for an indefinite period of time, but neither scenario of flat to down rates is a great outcome for bond holders.

Fixes to Fixed-Income Failings

Even though I may be a “bond hater” of low yield, high duration bonds, currently I still understand the critical importance and necessity of a fixed income portfolio for not only retirees, but also for the diversification benefits needed by a broader set of investors. So how does a bond hater reconcile investing in bonds? Easy. Rather than focusing on lower yielding, longer duration bonds, I invest more client assets in shorter duration and/or higher yielding bonds. If you harbor similar beliefs as I do, and believe there will be an upward bias to the trajectory of long-term interest rates, then there are two routes to go. Investors can either get compensated with a higher yield to counter the increased interest rate risk, and/or they can shorten duration of bond holdings to minimize capital losses.

Worth noting, there is an alternative strategy for low yielding, long duration bond lovers. In order to minimize interest rate risk, these bond lovers may accept sub-optimal yields and hold bonds to maturity. This strategy may be associated with short-term price volatility, but if the bond issuer does not default, at least the bond investor will get the full principal at maturity to help relieve the pain of meager yields.

Now that you’ve survived all this bond babbling, let me cut to the chase and explain a few ways Sidoxia is taking advantage of the recent interest rate volatility for our clients:

Floating Rate Bonds: Duration of these bonds is by definition low, or near zero, because as interest rates rise, coupons/interest payments are advantageously reset for investors at higher rates. So if interest rates jump from 2% to 3%, the investor will receive +50% higher periodic payments.

Inflation Protection Bonds: These bonds come in long and short duration flavors, but if interest rates/inflation rise higher than expected, investors will be compensated with higher periodic coupons and principal payments.

Shorter Duration: One definition of duration is the weighted average of time until a bond’s fixed cash flows are received. A way of shortening the duration of your bond portfolio is through the purchase of shorter maturity bonds (e.g., buying 3-year bonds rather than 30-year bonds).

High Yield Bonds: Investing in the high yield bond category is not limited to domestic junk bond purchases, but higher yields can also be earned by investing in international and/or emerging market bonds.

Investment Grade Corporate Bonds: Similar to high yield bonds, investment grade bonds offer the potential of capital appreciation via credit improvement. For instance, credit rating upgrades can provide gains to help offset price declines caused by rising interest rates.

Despite my bond hater status, the recent taper tantrum and interest rate spike, highlight some advantages bonds have over stocks. Even though prices declined, bonds by and large still have lower volatility than stocks; provide a steady stream of income; and provide diversification benefits.

To the extent investors have, or should have, a longer-term time horizon, I still am advocating a stock bias to client portfolios, subject to each investor’s risk tolerance. For example, an older retired couple with a conservative target allocation of 20%/80% (equity/fixed income) may consider a 25% – 30% allocation. A shift in this direction may still meet the retirees’ income needs (especially if dividend-paying stocks are incorporated), while simultaneously acknowledging the inflation and interest rate risks impacting bond positions. It’s important to realize one size doesn’t fit all.

Higher Volatility, Higher Reward

Frequent readers of Investing Caffeine have known about my bond hating tendencies for quite some time (see my 2009 article Treasury Bubble has not Burst…Yet), but the bond baby shouldn’t be thrown out with the bath water. For those investors who thought bonds were as safe as CDs, the recent -6% drop in the iShares Aggregate Bond Index (AGG) didn’t feel comfortable for most. Although I am still an enthusiastic stock cheerleader (less so as valuation multiples expand), there has been a cost for the gargantuan outperformance of stocks since March of ’09. While stocks have outperformed bonds (S&P vs. AGG) by more than +140%, equity investors have had to endure two -10% corrections and two -20% corrections (e.g.,Flash Crash, Debt Ceiling Debate, European Financial Crisis, and Sequestration/Elections). If investors want to earn higher long-term equity returns, this desire will translate into more volatility than bonds…and more Tums.

I may still be a bond hater, and the general public remains firm stock haters, but at some point in the multi-year future, I will not be surprised to hear myself say, “Hi my name is Wade, and I am addicted to bonds.” In the mean time, Sidoxia will continue to optimize its client bond portfolios for a rising interest rate environment, while also investing in attractive equity securities and ETFs. There’s nothing to hate about that.

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), including floating rate bonds/loan funds, inflation-protection funds, corporate bond ETF, high-yield bond ETFs, and other bond ETFs, but at the time of publishing, SCM had no direct position in AGG or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

July 20, 2013 at 4:05 pm 2 comments

1994 Bond Repeat or 2013 Stock Defeat?

Question

Interest rates are moving higher, bond prices are collapsing, and fear regarding a stock market plunge is palpable. Sound like a recent news headline or is this a description of a 1994 financial market story? For those with a foggy, double-decade-old memory, here is a summary of the 1994 economic environment:

  • The economy registered its 34th month of expansion and the stock market was on a record 40-month advance
  • The Federal Reserve embarked on its multi-hike, rate-tightening monetary policy
  • The 10-year Treasury note exhibited an almost 2.5% jump in yields
  • Inflation was low with a threat of rising inflation lurking in the background
  • An upward sloping yield curve encouraged speculative bond carry-trade activity (borrow short, invest long)
  • Globalization and technology sped up the pace of price volatility

Many of these listed items resemble factors experienced today, but bond losses in 1994 were much larger than the losses of 2013 – at least so far. At the time, Fortune magazine called the 1994 bond collapse the worst bond market loss in history, with losses estimated at upwards of $1.5 trillion. The rout started with what might have appeared as a harmless 0.25% increase in the Federal Funds rate (the rate that banks lend to each other) from 3% to 3.25% in February 1994. By the time 1994 came to a close, acting Federal Reserve Chairman Alan Greenspan had jacked up this main monetary tool by 2.5%.

Rising rates may have acted as the flame for bond losses, but extensive use of derivatives and leverage acted as the gasoline. For example, over-extended Eurobond positions bought on margin by famed hedge fund manager Michael Steinhardt of Steinhardt Partners lead to losses of about-30% (or approximately $1.5 billion). Renowned partner of Omega Partners, Leon Cooperman, took a similar beating. Cooperman’s $3 billion fund cratered -24% during the first half of 1994. Insurance company bond portfolios were hit hard too, as collective losses for the industry exceeded $20 billion, or more than the claims paid for Hurricane Andrew’s damage. Let’s not forget the largest casualty of this era – the public collapse of Orange County, California. Poor derivatives trades led to $1.7 billion in losses and ultimately forced the county into bankruptcy.

There are plenty of other examples, but suffice it to say, the pain felt by other bond investors was widespread as a massive number of margin calls caused a snowball of bond liquidations. The speed of the decline was intensified as bond holders began selling short and using derivatives to hedge their portfolios, accelerating price declines.

Just as the accommodative interest rate punch bowl was eventually removed by Greenspan, so too is Ben Bernanke (current Fed Chairman) threatening to do today. Even if Bernanke unleashes a cold-turkey tapering of the $85 billion per month in bond-purchases, massive losses in bond values won’t necessarily mean catastrophe for stock values. For evidence, one needs to look no further than this 1994-1995 chart of the stock market:

Source: Ciovaccocapital.com

Source: Ciovaccocapital.com

Volatility for stocks definitely increased in 1994 with the S&P 500 index correcting about -10% early in the year. But as you can see, by the end of the year the market was off to the races, tripling in value over the next five years. Volatility has been the norm for the current bull market rally as well. Despite the more than doubling in stock prices since early 2009, we have experienced two -20% corrections and one -10% pullback.

What’s more, the onset of potential tapering is completely consistent with core economic principles. Capitalism is built on free trading markets, not artificial intervention. Extraordinary times required extraordinary measures, but the probabilities of a massive financial Armageddon have been severely diminished. As a result, the unprecedented scale of quantitative easing (QE) will eventually become more harmful than beneficial. The moral of the story is that volatility is always a normal occurrence in the equity markets, therefore any significant stock pullback associated with potential bond tapering (or fed fund rate hikes) shouldn’t be viewed as the end of the world, nor should a temporary weakening in stock prices be viewed as the end to the bull market in stocks.

Why have stocks historically provided higher returns than bonds? The short answer is that stocks are riskier than bonds. The price for these higher long-term returns is volatility, and if investors can’t handle volatility, then they shouldn’t be investing in stocks.

If you are an investor that thinks they can time the market, you wouldn’t be wasting your time reading this article. Rather, you’d be spending time on your personal island while drinking coconut drinks with umbrellas (see Market Timing Treadmill).

Although there are some distinct similarities between the economic backdrop of 1994 and 2013, there are quite a few differences also. For starters, the economy was growing at a much healthier clip then (+4.1% GDP growth), which stoked inflationary fears in the mind of Greenspan. Moreover, unemployment was quite low (5.5% by year-end vs. 7.6% today) and the Fed did not communicate forward looking Fed policy back then.

It’s unclear if the recent 50 basis point ascent in 10-year Treasury rates was just an appetizer for what’s to come, but simple mathematics indicate there is really only one direction left for interest rates to go…higher. If history repeats itself, it will likely be bond investors choking on higher rates (not stock investors). For the sake of optimistic bond speculators, I hope Ben Bernanke knows the Heimlich maneuver. Studying history may help bond bulls avoid indigestion.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

June 8, 2013 at 11:14 pm Leave a comment

Bond-Choking Central Banks Expand Investment Menu

iStock_000005933551XSmallMenu

Central banks around the globe are choking on low-yielding bonds, and as result are now expanding their investment menu beyond Treasuries into equities. Expansionary monetary policies purchasing short-term, low-rate bonds means that central banks have been gobbling up securities on their balance sheets that are earning next to nothing. To counteract the bond-induced indigestion of the central banks, many of them are considering increasing their equity purchasing strategies. How can you blame them? With the 10-year U.S. Treasury notes yielding 1.66%; 10-year German bonds eking out 1.21%; and 10-year Japanese Government Bonds (JGBs) paying a paltry 0.59%, it’s no wonder central banks are looking for better alternatives.

More specifically, the Bank of Japan (BOJ) is planning to pump $1.4 trillion into its economy over the next two years to encourage some inflation through open-ended asset purchases. Earlier this month, the BOJ said it has a goal of more than doubling equity related exchange traded funds (ETFs) by the end of 2014. According to Business Insider, the BOJ is currently holding $14.1 billion in equity ETFs with an objective to reach $35.3 billion in 2014.

I can only imagine how stock market bears feel about this developing trend when they have already blamed central banks’ quantitative easing initiatives as the artificial support mechanism for stock prices (see also The Central Bank Dog Ate my Homework).

While expanded equity purchases could break the backs of bond bulls and stock naysayers, some smart people agree that this strategy makes sense. Take Jim O’Neill, the chairman of Goldman Sachs Asset Management, who is retiring next week. Here’s what he has to say about expanded central bank stock purchases:

“Frankly, it makes a huge amount of sense in a world of floating exchange rates and such incredible opportunity, why should central banks keep so much money in very short term, liquid things when they’re not going to ever need it? To help their future returns for their citizens, why would they not invest in equity?”

 

How big is this shift towards equities? The Royal Bank of Scotland conducted a survey of 60 central banks that have about $6.7 trillion in reserves. There were 13% of the central banks already invested in equities, and almost 25% of them said they are or will be invested in equities within the next five years.

While I may agree that stocks generally are a more attractive asset class than bubblicious bonds right now, I may draw the line once the Fed starts buying houses, gasoline, and groceries for all Americans. Until then, dividend yields remain higher than Treasury yields, and the earnings yields (earnings/price) on stocks will remain more attractive than bond yields. Once stocks gain more in price and/or bonds sell off significantly, it will be a more appropriate time to reassess the investment opportunity set. A further stock rise or bond selloff are both possible scenarios, but until then, central banks will continue to look to place its money where it is treated best.

The central bank menu has been largely limited to low-yielding, overpriced government bonds, but the appetite for new menu items has heightened.  Stocks may be an enticing new option for central banks, but let’s hope they delay buying houses, gasoline, and groceries.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

April 28, 2013 at 11:31 am Leave a comment

Beware: El-Erian & Gross Selling Buicks…Not Chevys

Car Salesman and a Customer

As my grandmother always told me, “Be careful where you get your advice!” Or as renowned Wall Street trader Gerald Loeb once said, “The Buick salesman is not going to tell you a Chevrolet will fit your needs.” In other words, when it comes to investment advice, it is important to realize that opinions and recommendations are often biased and steeped with inherent conflicts of interest. Having worked in the financial industry over several decades, I have effectively seen it all.

However, one unique aspect I have grown accustomed to is the nauseating and fatiguing over-exposure of PIMCO’s dynamic bond duo, CEO Mohamed El-Erian and founder Bill Gross. Over the last four years and 13 consecutive quarters of GDP growth (likely 14 after Q4 revisions), I and fellow CNBC viewers have been forced to endure the incessant talk of the “New Normal” of weak economic growth to infinity. Actual results have turned out quite differently than the duet’s cryptic and verbose predictions, which have piled up over their seemingly non-stop media interview schedule. Despite the doomsday rhetoric from the bond brothers, El-Erian and Gross have witnessed a more than doubling in equity prices, which has soundly trounced the performance of bonds over the last four years.

After being mistaken for such a long period, certainly the PIMCO marketing machine would revise their pessimistic outlook, right? Wrong. In true biased fashion, El-Erian cannot admit defeat. Just this week, El-Erian argues stocks are artificially high due to excessive liquidity pumped into the financial system by central banks (see video below). I’m the first one to admit Federal Reserve Chairman Ben Bernanke is explicitly doing his best to force investors into risky assets, but doesn’t generational low interest rates help bond prices too? Apparently that mathematical fact has escaped El-Erian’s bond script.

Source: Yahoo! Finance (Daily Ticker)

Source: Yahoo! Finance (Daily Ticker)

El-Erian’s buddy, Bill Gross, can’t help himself from jumping on the stock rain parade either. Just six weeks ago Gross followed the bond-pumping playbook by making another dour prediction that the market would rise less than 5% in 2013. Unfortunately for Gross, his crystal ball has also been a little cloudy of late, with the S&P 500 index already up more than +6.5% this year. Since doomsday outlooks are what keeps the $2 trillion PIMCO machined primed, it’s no surprise we hear about the never-ending gloom. For those keeping score at home, let’s please not forget Bill Gross’s infamously wrong Dow 5,000 prediction (see article).

PIMCO Smoke & Mirrors: Stock Funds with NO Stocks

Just when I thought I had seen it all, I came across PIMCO’s Equity-Related funds. Never in my career have I seen “equity” mutual funds that invest solely in “bonds.” Well, apparently PIMCO has somehow creatively figured out how to create stock funds without investing in stocks. I guess that is one strategy for a bond-centric company of getting into the equity fund market? This is either ingenious or bordering on the line of criminal. I fall into the latter camp. How the SEC allows the world’s largest bond company to deceivingly market billions in bond-filled stock funds to individual investors is beyond me. After innocent people got fleeced by unscrupulous mortgage brokers and greedy lenders, in this Dodd-Frank day and age, I can’t help but wonder how PIMCO is able to solicit a StockPlus Fund that has 0% invested in common stocks. You can judge for yourself by reviewing their equity-related funds on their website (see also chart below):

PIMCO Equity-Related Funds with NoEquity

PIMCO Equity-Related Funds with No Equity

PIMCO Active Equity Funds Struggle

With more than 99% of PIMCO’s $2 trillion in assets under management locked into bonds, company executives have made a half-hearted effort of getting into the equity markets, even though they’ve enjoyed high-fiving each other during the three-decade-long bond bull market (see Downhill Marathon Machine). In hopes of diversifying their bond-heavy revenue stream, in 2009 they hired the head of the high-profile $700 billion, government TARP program (Neil Kashkari). Subsequently, PIMCO opened its first set of actively managed funds in 2010. Regrettably for PIMCO, the sledding has been quite tough. In 2012, all six actively managed equity funds lagged their benchmarks. Moreover, just a few weeks ago, Kashkari their rock star hire decided to quit and pursue a return to politics.

Mohamed El-Erian and Bill Gross have never been camera shy or bashful about bashing stocks. PIMCO has virtually all their bond eggs in one basket and their leaderless equity division is struggling. What’s more, like some car salesmen, they have had a creative way of describing the facts. If it’s a Chevy or unbiased advice you’re looking for, I recommend you steer clear from Buick salesmen and PIMCO headquarters.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in PIMCO funds,  or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

February 18, 2013 at 8:40 am 3 comments

Rates Dance their Way to a Floor

The globe is awash in debt, deficits are exploding, and the Euro is about to collapse…right? Well, then why in the heck are six countries out of the G-7 seeing their 10-year sovereign debt trade at 2.5% or lower on a consistent downward long-term trajectory? What’s more, three of the six countries witnessing their rates plummet are from Europe, despite pundits continually calling for the demise of the eurozone.

Here is a snapshot of 10-year sovereign debt yields for the majority of the G-7 countries over the last few decades:

Source: TradingEconomics.com

The sole G-7 member missing from the bond yield charts above? Italy. Although Italy’s deficits are not massive (Italy actually has a smaller deficit than U.S. as % of GDP: 3.9% in 2011), its Debt/GDP ratio has been large and rising (see chart below):

Source: TradingEconomics.com

As the globe has plodded through the financial crisis of 2008-2009, investors have flocked to the perceived stability of these larger developed countries’ bonds, even if they are merely better homes in a bad neighborhood right now. PIMCO likes to call these popular sovereign bonds, “cleaner dirty shirts.” Buying sovereign debt from these less dirty shirt countries, without sensitivity to price or yield, has been a lucrative trade that has worked consistently for quite some time. Now, however, with sovereign bond yields rapidly approaching 0%, it becomes mathematically impossible to fall lower than the bottom rate floor that developed countries are standing on.

Bond bears have been wrong about the timing of the inevitable bond price reversal, myself included, but the bulls are skating on thinner and thinner ice as rates continue moving lower. The bears may prolong their bragging rights if interest rates continue downward, or persist at these lower levels for extended periods of time. Eventually the “buy the dips” mentality dies, as we so poignantly experienced in 2000 when the technology dips turned into outright collapse.

The Flies in the Bond Binging Ointment

As long as equities remain in a trading range, the “risk-off” bond binging arguments will continue holding water. If corporate earnings remain elevated and stock buybacks carry on, the pain of deflating real returns will eventually become too unbearable for investors. As the insidious rising prices of energy, healthcare, food, leisure, and general costs keep eating away everyone’s purchasing power, even the skeptics will become more impatient with the paltry returns they are currently earning. Earning negative real returns in Treasuries, CDs, money market accounts, and other conservative investments, is not going to help millions of Americans meet their future financial goals. Due to the laundry list of global economic concerns, large swaths of investors are still running and hiding, but this is not a sustainable strategy longer term. The danger from these so-called “safe,” low-yielding asset classes is actually riskier than the perceived risk, in my view.

With that said, I’ve consistently held there are a subset of investors, including a significant number of my Sidoxia Capital Management clients, who are in the later stage of retirement and have a rational need for capital preservation and income generating assets (albeit low yielding). For this investor segment, portfolio construction is not executed due to an opportunistic urge of chasing potential outsized rates of return, but more-so out of necessity. Shorter time horizons eliminate the prudence of additional equity exposure because of the extra associated volatility. Unfortunately, many of the 76 million Baby Boomers will statistically live another 20 – 30 years based on actuarial life expectations and under-save, so the risks of being too conservative can dramatically outweigh the risks of increasing equity exposure. This is all stated in the context of stocks paying a higher yield than long-term Treasuries – the first time in a generation.

Short-term risks and uncertainties remain high, with Greek election outcomes unknown; a U.S. Presidential election in flux; and an impending domestic fiscal cliff that needs to be addressed. But with interest rates accelerating towards 0% and investors’ fright-filled buying of pricey, low-yielding asset classes, many of these risks are already factored into current valuations. As it turns out, the pain of panic can be more detrimental than being stuck in over-priced assets, driven by rates dancing near an absolute floor.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

June 10, 2012 at 9:25 pm 1 comment

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