Archive for July, 2013
Life has been challenging for the bears over the last four years. For the first few years of the recovery (2009-2010) when stocks vaulted +50%, supposedly we were still in a secular bear market. Back then the rally was merely dismissed as a dead-cat bounce or a short-term cyclical rally, within a longer-term secular bear market. Then, after an additional +50% move the commentary switched to, “Well, we’re just in a long-term trading range. The stock market hasn’t done a thing in a decade.” With major indexes now hitting all-time record highs, the pessimists are backpedaling in full gear. Watching the gargantuan returns has made it more difficult for the bears to rationalize a tripling +225% move in the S&P 600 index (Small-Cap); a +214% move in the S&P 400 index (Mid-Cap); and a +154% in the S&P 500 index (Large-Cap) from the 2009 lows.
For the unfortunate souls who bunkered themselves into cash for an extended period, the return-destroying carnage has been crippling. Making matters worse, some of these same individuals chased a frothy over-priced gold market, which has recently plunged -30% from the peak.
Bonds have generally been an OK place to be as Europe imploded and domestic political gridlock both helped push interest rates to record-lows (e.g., tough to go lower than 0% on the Fed-Funds rate). But now, those fears have subsided, and the recent rate spike from Ben Bernanke’s “taper tantrum” has caused bond bulls to reassess their portfolios (see Fed Fatigue). Staring at the greater than -90% underperformance of bonds, relative to stocks over the last four years, has been a bitter pill to swallow for fervent bond believers. The record -$9.9 billion outflow from Mr. New Normal’s (Bill Gross) Pimco Total Return Fund in June (a 26-year record) is proof of this anxiety. But rather than chase an unrelenting stock market rally, stock haters and skeptics remain stubborn, choosing to place their bond sale proceeds into their favorite inflation-depreciating asset…cash.
Crash Diet at the Buffet
I’ve seen and studied many markets in my career, but the behavioral reactions to this most-hated bull market in my lifetime have been fascinating to watch. In many respects this reminds me of an investing buffet, where those participating in the nourishing market are enjoying the spoils of healthy returns, while the skeptical observers on the sidelines are on a crash diet, selecting from a stingy menu of bread and water. Sure, there is some over-eating, heartburn, and food coma experienced by those at the stock market table, but one can only live on bread and water for so long. The fear of losses has caused many to lose their investing appetite, especially with news of sequestration, slowing China, Middle East turmoil, rising interest rates, etc. Nevertheless, investors must realize a successful financial future is much more like an eating marathon than an eating sprint. Too many retirees, or those approaching retirement, are not responsibly handling their savings. As legendary basketball player and coach John Wooden stated, “Failing to prepare is preparing to fail.”
20 Years…NOT 20 Days
I will be the first to admit the market is ripe for a correction. You don’t have to believe me, just take a look at the S&P 500 index over the last four years. Despite the explosion to record-high stock prices, investors have had to endure two corrections averaging -20% and two other drops approximating -10%. Hindsight is 20-20, but at each of those fall-off periods, there were plenty of credible arguments being made on why we should go much lower. That didn’t happen – it actually was the opposite outcome.
For the vast majority of investing Americans, your investing time horizon should be closer to 20 years…not 20 days. People that understand this reality realize they are not smart enough to consistently outwit the market (see Market Timing Treadmill). If you were that successful at this endeavor, you would be sitting on your private, personal island with a coconut, umbrella drink.
Successful long-term investors like Warren Buffett recognize investors should “buy fear, and sell greed.” So while this most hated bull market remains fully in place, I will follow Buffett’s advice comfortably sit at the stock market buffet, enjoying the superior long-term returns put on my plate. Crash dieters are welcome to join the buffet, but by the time they finally sit down at the stock market table, I will probably have left to the restroom.
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 IJR, and IJH, but at the time of publishing, SCM had no direct position in BRKA/B, Pimco Total Return Fund, 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.
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.
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.
On a daily basis, I make my way into the office before the market opening bell, preparing myself to gorge on a massive heaping of news stories and headlines. But scarfing down tons of tweets and hundreds of headlines is not enough. Magazines, newspapers, conference calls, blogs, presentations, conferences, interviews, television clips, and software lists are but just a few additional aspects to my steady diet of information. Like shopping down each and every aisle of the grocery store, an annoying tendency I admittedly commit, there are plenty of healthy and unhealthy items to choose from. The key is identifying the items that are the best for your financial health. After carrying out this gluttonous information-stuffing business for more than twenty years, I’ve gotten much better at separating the data wheat from information chaff. This is critical in avoiding heartburn for my Sidoxia clients and me.
One might ask, “What harmless headline or innocent anecdote could possibly cause harmful financial indigestion?” I don’t know about you, but in recent months, gobbling down these following headlines without discretion can lead to a serious case of acid reflux:
- “Stocks Tumble as Bernanke Discusses Tapering” – USA Today
- “China’s Economy is Freezing Up. How Freaked Out Should We Be?” – Washington Post
- ” ‘Suffocating in the Streets’: Chemical Weapons Attack Reported in Syria” – NBC News
- “Europe’s Zombie Banks – Blight of the Living Dead” – The Economist
- “Threats from Extremists as Egypt Slides into Turmoil” – The Times
- “Japan Market Plunge Sparks Global Sell-Off” – Los Angeles Times
I think you get the idea. No wonder investors collectively are acting like a deer in headlights, resulting in declining stock market participation – a 15-year low (see Investing Caffeine’s DMV Economy)
In the world of competitive eating, the execution of improper consumption technique can lead to a so-called “reversal of fortune,” as can be experienced by the last video on my Investing Caffeine article, Baseball and Hot Dogs. Disciplined processes are needed to prevent such an event when devouring excessive amounts of information. This is a timely topic as Joey Chestnut recently set a new world record by eating 69 hot dogs in 10 minutes.
While digesting the avalanche of daily data is quite complex, understanding the harmful consequences of doing so is quite simple. Carl Richards, a contributor writer to the The New York Times and Morningstar Advisor does a great job of outlining the detrimental impact of information consumption on investors’ wealth and happiness through minimalist charts found at BehaviorGap.com.
Here is my co-mingled version of Richards’ work:
As Mark Twain said, “If you don’t read the newspaper, you are uninformed. If you do read the newspaper, you are misinformed.” It’s perfectly fine to remain current with major economic, political, and worldly events, but the consequences to overreacting to the ever-changing news flow can be disastrous to your financial and personal well-being. Managing your life savings can be stressful and if not managed correctly will damage your financial goals.
If you do not have the time, interest, or self-control to digest the massive buffet of endless information, do yourself a favor and find an experienced and trusted advisor that can assist you with the Heimlich maneuver, so you don’t choke on the infinite amount of data.
See also (Investing Caffeine: Age of Information Overload)
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) and CMCSA, but at the time of publishing, SCM had no direct position in GCI, WPO, NYT, MORN 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.
If you have ever gone to get your driver’s license at the Department of Motor Vehicles (DMV)…you may still be waiting in line? It’s a painful but often a mandatory process, and in many ways the experience feels a lot like the economic recovery we currently have been living through over the last four years. Steady progress is being made, but in general, people hardly notice the economy moving forward.
My geographic neighbor and blogger here in Orange County, California (Bill McBride – Calculated Risk) has some excellent visuals that compare our sluggish DMV economy with previous economic cycles dating back to 1948:
As you can see from the chart above, the current economic recovery (red-line), as measured by job losses, is the slowest comeback in more than a half-century. Basically, over a two year period, the U.S. lost about nine million jobs, and during the following three years the economy regained approximately seven million of those jobs – still digging out of the hole. Last Friday’s June jobs report was welcomed, as it showed net jobs of +195,000 were added during the month, and importantly the previous two months were revised higher by another +70,000 jobs. These data points combined with last month’s Fed’s QE3 tapering comments by Ben Bernanke help explain why the continued rout in 10 year Treasury rates has continued in recent weeks, propelling the benchmark rate to 2.71% – almost double the 1.39% rate hit last year amidst continued European financial market concerns.
As with most recessions or crashes, the bursting of the bubble (i.e., damage) occurs much faster than the inflation (i.e., recovery), and McBride’s time series clearly shows this fact:
While pessimists point to the anemic pace of the current recovery, the glass half-full people (myself included) appreciate that the sluggish rebound is likely to last longer than prior recoveries. There are two other key dynamics underlying the reported employment figures:
- Continued Contraction in Government Workers: Excessive government debt and deficits have led to continued job losses – state and local job losses appear to be stabilizing but federal cuts are ongoing.
- Decline in the Labor Force Participation Rate: Discouraged workers and aging Baby Boomer demographics have artificially lowered the short-term unemployment figures because fewer people are looking for work. If economic expansion accelerates, the participation contraction trend is likely to reverse.
Skepticism Reigns Supreme
Regardless of the jobs picture and multi-year expansion, investors and business managers alike remain skeptical about the sustainability of the economic recovery. Anecdotally I encounter this sentiment every day, but there are other data points that bolster my assertion. Despite the stock market more than doubling in value from the lows of 2009, CNBC viewer ratings are the weakest in about 20 years (see Value Walk) and investments in the stock market are the lowest in 15 years (see Gallup poll chart below):
Why such skepticism? Academic research in behavioral finance highlights innate flaws in human decision-making processes. For example, humans on average weigh losses twice as much as gains as economist and Nobel prizewinner Daniel Kahneman explains in his book Thinking Fast and Slow (see Investing Caffeine article: Decision Making on Freeways and in Parking Lots). Stated differently, the losses from 2008-2009 are still too fresh in the minds of Americans. Until the losses are forgotten, and/or the regret of missing gains becomes too strong, many investors and managers will fearfully remain on the sideline.
The speed of our economic recovery is as excruciatingly agonizing, and so is waiting in line at the DMV. The act of waiting can be horrific, but obtaining a driver’s license is required for driving and investing is necessary for retirement. If you don’t want to go to investing jail, then you better get in the investing line now before job growth accelerates, because you don’t want to be sent to the back of the line where you will have to wait longer.
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.
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (July 1, 2013). Subscribe on the right side of the page for a complete monthly update.
Deciphering what is driving the markets on a day-to-day, week-to-week, or month-to-month basis can feel like repeatedly hammering your head. In order to grasp the reasons why financial markets go up and down, one must have a conversation with your brain explaining that good news can be bad for asset prices, and bad news can be good for asset prices. Huh…how can that be? These circular conversations are what keep newspapers, magazines, media commentators, and bloggers in business… and what baffle many investors.
For example, headlines often reflect sentiments such as these:
- “Unemployment Figures Disappoint…Dow Jones Rallies +200 Points on QE3 Continuation Hopes”
- “Unemployment Figures Delight…Dow Jones Tanks -200 Points on QE3 Discontinuation Fears”
- “Economic Figures Revised Lower by -0.2%…Dow Jones Skyrockets +200 Points as Lower Interest Rates Propel Stock Prices.”
- “Economic Figures Revised Higher by +0.2%…Dow Jones Plummets -200 Points as Higher Interest Rates Deflate Stock Prices.”
On rare occasions these headlines make sense, but often online media outlets are frantically changing the headlines as the markets whip back and forth from positive to negative. News-producing editors are continually forced to create ludicrous and absurd explanations that usually make no sense to informed long-term investors.
It’s important to recognize that if the financial markets made common sense, then investing for retirement would be simple and everyone would be billionaires. Unfortunately, financial markets frequently make no sense in the short-run. Stocks are volatile (often times for no rational reason), which is why stocks offer higher returns over the long-run relative to more stable asset classes.
Explaining the latest spike in stock/bond price volatility has been exacerbated in recent weeks as a result of the nation’s banker (the Federal Reserve) and its boss, Ben Bernanke, attempting to explain their future monetary policy plans. In theory, bringing light to a traditionally mysterious, closed-door Washington process should be a good thing…right?
Well, ever since a few weeks ago when Ben Bernanke and the FOMC (Federal Open Market Committee) disclosed that the stimulative bond buying program (QE3) could be slowed in 2013 and halted in 2014, financial markets globally experienced a sharp jolt of volatility – stock prices dropped and interest rates spiked. Counter-intuitively, Bernanke’s belief that the economy is on a sustained recovery path (expected GDP growth of +3.25% in both 2014 & 2015) spooked investors. More specifically, in the month of June, the S&P 500 index declined -1.5% in June; Dow Jones Industrial Index -1.4%; and the 10-year Treasury note’s yield jumped +0.3% to 2.5%. Greedy investors, however, should not forget that the stock market just posted its 2nd best quarter since 2009 – the S&P 500 climbed +2.4%. What’s more, the S&P 500 is up +13% and the Dow up +14% in the first half of 2013.
Bernanke Threatening to Take Away Investor Lollipops
Another way of looking at the recent volatility is by equating investors to kids and stimulative QE bond buying programs (Quantitative Easing) to lollipops. If the economy continues on this improvement trajectory (i.e., unemployment falls to 7% by next year) and inflation remains benign (below 2.5%), then Bernanke said he will take away investors’ QE lollipops. But like a pushover dad being pressured by kids at the candy store, Bernanke acknowledged that he could continue supplying investors QE lollipops, if the economic data doesn’t improve at the forecasted pace. At face value, receiving a specific timeline given by the Fed should be appreciated and normally people are happy to hear the Chairman speak rosily about the economy’s future. However, the mere thought of QE lollipops being taken away next year was enough to push investors into a “taper tantrum” (see also Investing Caffeine – Fed Fatigue article).
With scary headlines constantly circulating, a large proportion of investors are sitting on their hands (and cash) while staring like deer in headlights at these developments. Rather than a distracted driver texting, investors should be watching the road and mapping out their future investment destinations – not paying attention to irrelevant diversions. Astute investors realize that uncertainty surrounding Greece, Cyprus, fiscal cliff, sequestration, presidential elections, Iran, N. Korea, Syria, Turkey, taxes, QE3, etc., etc., etc., have been a constant. Regrettably the fear mongers paying attention to these useless headlines have witnessed their cash, gold, and Treasuries get trounced by equity returns since early 2009 (the S&P 500 index is up about +150%, including dividends). Optimists and realists, on the other hand, have seen their investment plans thrive. While the aforementioned list of concerns has dangled in front of our noses over the last year, we will have a complete new list of concerns to decipher over the coming weeks, months, and years. That’s the price a long-term investor pays if they want to earn higher returns in the volatile equity markets.
As strategist Don Hays points out, “Nothing is certain. Good investors love uncertainty.” Rather than getting consumed by fear with the endless number of changing uncertainties, the real risk for investors is outliving your savings. Paychecks are being stretched by inflationary pressures across all categories (e.g., healthcare, gasoline, utilities, food, movies, travel, etc.) and entitlements like Social Security and Medicare will likely not mean the same thing to us as it did for our parents. Unless investors plan on working into their 80s as greeters at Wal-Mart, and/or enjoy clipping Top Ramen coupons in a crammed apartment, then they should do themselves a favor by taking a deep breath and turning off the television, so they can be insulated from the constant doom and gloom.
So as intimidating, circular conversations about good news being bad news, and bad news being good news continue to swirl around, focus instead on building a diversified investment plan that can adjust and adapt to the never-ending list of uncertainties. Your head will feel a lot better than it would after repetitive hammer strikes.
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) and WMT, 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.