Posts tagged ‘bonds’
Equity Quicksand or Bond Cliff?
The markets are rigged, the Knight Capital Group (KCG) robots are going wild, and the cheating bankers are manipulating Libor. I guess you might as well pack it in…right? Well, maybe not. While mayhem continues, equity markets stubbornly grind higher. As we stand here today, the S&P 500 is up approximately +12% in 2012 and the NASDAQ market index has gained about +16%? Not bad when you consider 15 countries are offering negative yields on their bonds…that’s right, investors are paying to lose money by holding pieces of paper until maturity. As crazy as buying technology companies in the late 1990s for 100x’s or 200x’s earnings sounds today, just think how absurd negative yields will sound a decade from now? For heaven’s sake, buying a gun and stuffing money under the mattress is a cheaper savings proposition.
Priced In, Or Not Priced In, That is the Question?
So how can stocks be up in double digit percentage terms when we face an uncertain U.S. presidential election, a fiscal cliff, unsustainable borrowing costs in Spain, and S&P 500 earnings forecasts that are sinking like a buried hiker in quicksand (see chart below)?
I guess the answer to this question really depends on whether you believe all the negative news announced thus far is already priced into the stock market’s below average price-earnings (P/E) ratio of about 12x’s 2013 earnings. Or as investor Bill Miller so aptly puts it, “The question is not whether there are problems. There are always problems. The question is whether those problems are already fully discounted or not.”
Source: Crossing Wall Street
While investors skeptically debate how much bad news is already priced into stock prices, as evidenced by Bill Gross’s provocative “The Cult of Equity is Dying” article, you hear a lot less about the nosebleed prices of bonds. It’s fairly evident, at least to me, that we are quickly approaching the bond cliff. Is it possible that we can be entering a multi-decade, near-zero, Japan-like scenario? Sure, it’s possible, and I can’t refute the possibility of this extreme bear argument. However with global printing presses and monetary stimulus programs moving full steam ahead, I find it hard to believe that inflation will not eventually rear its ugly head.
Again, if playing the odds is the name of the game, then I think equities will be a better inflation hedge than most bonds. Certainly, not all retirees and 1%-ers should go hog-wild on equities, but the bond binging over the last four years has been incredible (see bond fund flows).
While we may sink a little lower into the equity quicksand while the European financial saga continues, and trader sentiment gains complacency (Volatility Index around 15), I’ll choose this fate over the inevitable bond cliff.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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 KCG 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.
Digesting the Anchovy Pizza Market
Source: Photobucket
Article is an excerpt from previously released Sidoxia Capital Management’s complementary July 2012 newsletter. Subscribe on right side of page.
I love pizza, and most fellow connoisseurs have difficulty refusing a hot, fresh slice of heaven too. Pizza is so universally appreciated that people consider pizza like ice cream – it’s good even when it’s bad (I agree). However, even the biggest, diehard pizza-lover will sheepishly admit their fondness for the flat and circular cheesy delight changes when you integrate anchovies into the mix. Not many people enjoy salty, slimy, marine creatures layered onto their doughy mozzarella and marinara pizza paradise.
With all the turmoil and uncertainty going on in the global financial markets, prudently investing in a widely diversified portfolio, including a broad range of equity securities, is viewed as palatable as participating in an all-you-can-eat anchovy pizza contest. Why are investors’ appetites so salty now? Hmmm, let me think. Oh yes, here are a few things that come to mind:
- Presidential Election Uncertainty
- European Financial Crisis
- Impending Fiscal Cliff (tax cut expirations, automatic spending cuts, termination of stimulus, etc.)
- Unsustainable Fiscal Debt & Deficits
- Slowing Subpar Domestic Economic Growth
- Partisan Politics and Gridlock in Washington
- High Unemployment
- Fears of a Hard Economic Landing in China
Doesn’t sound too appealing, does it? So, what are most investors doing in this unclear market? Rather than feasting on a pungent pie of anchovies, investors are flocking to the perceived safety of low yielding asset classes, no matter the price. In other words, the short-term warmth and comfort of CDs, money market, checking, and fixed income assets are being gobbled up like nicotine-laced pepperoni pizzas selling for $29.95/each + tax. The anchovy alternative, like stocks, is much more attractively priced now. After accounting for dividends, earnings, and cash flows, the anchovy/stock option is currently offering a 2-for-1 special with breadsticks and a salad…quite the bargain!
Nonetheless, the plain and expensive pepperoni/bond option remains the choice du jour and there are no immediate signs of a pepperoni hangover just quite yet. However, this risk aversion addiction cannot last forever. The bond gorging buffet has gone on relatively unabated for the last three decades, as you can see from the chart below. In spite of this, the bond binging game is quickly approaching a mathematical terminal end-game, as interest rates cannot logically go below zero.
Source: Calafia Beach Pundit with Sidoxia comments
Since my firm (Sidoxia Capital Management) is based in Newport Beach, next to PIMCO’s global headquarters, we get to follow the progression of the bond binging game firsthand. I’ve personally learned that if I manage close to $2 trillion in assets under management, I too can construct a 23-story Taj Mahal-esque headquarters that overlooks the Pacific Ocean from a stones-throw away.
Beyond glorified headquarters, there is evidence of other low-risk appetite examples. Here are some reinforcing pictures:
The Bond Binge
Source (The Financial Times): Bond purchases have exploded in the last three years.
Cash Hoarding
Source (Calafia Beach Pundit): Stuffing money under the mattress has accelerated in recent years as fear, uncertainty, and doubt have reigned supreme.
The Anchovy Special
Even though anchovy pizza, or a broadly diversified portfolio across asset class, size, geography, and style may not sound appealing, there are plenty of reasons to fight the urges of caving to fear and skepticism. Here are a few:
1) Growth Rolls On: Despite the aforementioned challenges occurring domestically and abroad, growth has continued unabated for 11 consecutive quarters, albeit at a rate less than desired. We are not immune to global recessionary forces, but regardless of European forces, the U.S. has been resilient in its expansion.
Source: Calafia Beach Pundit
2) Jobs and Housing on the Upswing: Unemployment remains high, but our country has experienced 27 consecutive months of private creation, leading to more than 4 million new jobs being added to our workforce. As you can see from the clear longer-term downward trend in unemployment claims, we are moving in the right direction.
Source: Calafia Beach Pundit
3) Eurozone Slowly Healing its Wounds: The Greek political and fiscal soap opera is grabbing all the headlines, but quietly in the background there are signs that the eurozone is slowly healing the wounds of the financial crisis. If you look at the 2-year borrowing costs of Europe’s troubled countries (ex-Greece), there is an unambiguous and beneficial decline. There is no doubt that Spain and Italy play a larger role than Portugal and Ireland, but at least some seeds of change have been planted for optimism.
Source: Calafia Beach Pundit
4) Record Corporate Profits: Investors are not the only people reading uncertain newspaper headlines and watching CNBC business television. CEOs are reading the same gloomy sensationalistic stories, and as a result, corporations have been cautious about dipping their short arms into their deep pockets. Significant expense reductions and a reluctance to hire have led to record profits and cash hoards. As evidenced by the chart below, profits continue to rise, and these earnings are being applied to shareholder friendly uses like dividends, share buybacks, and accretive acquisitions.
Source: Yardeni.com
5) Attractive Valuations (Pricing): We have already explored the lofty prices surrounding bonds and $30 pepperoni pizzas, but counter-intuitively, stock prices are trading at a discount to historical norms, despite record low interest rates. All else equal, an investor should pay higher prices for stocks when interest rates are at a record low (and vice versa), but currently we are seeing the opposite dynamic occur.
Source: Calafia Beach Pundit
Even though the financial markets may look, smell, and taste like an anchovy pizza, the price, value, and return benefits may outweigh the fishy odor. And guess what…anchovies are versatile. If you don’t like them on your pizza, you can always take them off and put them on your Caesar salad or use them for bait the next time you go fishing. The gloom-filled headlines haven’t been spectacular, but if they were, the return opportunities would be drastically reduced. Therefore you are much better off by following investor legend Warren Buffett’s advice, which is to “buy fear and sell greed.”
Investing has never been more difficult with record low interest rates, and it has also never been more important. Excluding a small minority of late retirees and wealthy individuals, efficiently investing your retirement dollars has become even more critical. The safety nets of Social Security and Medicare are likely to be crippled, which will require better and more prudent investing by individuals. Inflation relating to food, energy, healthcare, gasoline, and entertainment is dramatically eroding peoples’ nest eggs.
Digesting a pepperoni pizza may sound like the most popular and best option given the gloomy headlines and uncertain outlook, but if you do not want financial heartburn you may consider alternative choices. Like the healthier and less loved anchovy pizza, a more attractively valued strategy based on a broadly diversified portfolio across asset class, size, geography, and style may be the best financial choice to satiate your long-term financial goals.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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.
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.
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.
The Pleasure/Pain Principle
The financial crisis of 2008-2009 was painful, not to mention the Flash Crash of 2010; the Debt Ceiling / Credit Downgrade of 2011; and the never-ending European saga. Needless to say, these and other events have caused pain akin to burning one’s hand on the stove. This unpleasant effect has rubbed off on investors.
Admitting one has a problem is half the battle of conquering a challenge. A key challenge for many investors is understanding the crippling effects fear can have on personal investment decisions. While there are certainly investors who constantly see financial markets through rose-colored glasses (my glasses I argue are only slightly tinted), Nobel Prize winner Daniel Kahneman and his partner Amos Tversky understand the pain of losses can be twice as painful as the pleasure experienced through gains (see diagram below).
Source: Investopedia
Said a little differently, faced with sure gain, most investors are risk-averse, but faced with sure loss, investors prefer risk-taking. Don’t believe me? Well, let’s take a look at some of Kahneman and Tversky’s behavioral finance work on what they called “Prospect Theory” (1979) – the analysis of decisions made under various risk scenarios.
In one specific experiment, Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:
Problem #1: In addition to whatever you own, you have been given $1,000. You are now asked to choose between:
A. A sure gain of $500
B. A 50% change to gain $1,000 and a 50% chance to gain nothing.
Another group of subjects was presented with this problem:
Problem #2: In addition to whatever you own, you have been given $2,000. You are now asked to choose between:
A. A sure loss of $500
B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.
In the first group, 84% of the respondents chose A and in the second group, 69% of the respondents chose B. Both problems are identical in terms of the net cash outcomes ($1,500 for Answer A, and 50% chance of $1,000 or $2,000 for Answer B). Nonetheless, due the different “loss phrasing” in each question, Answer A sounds more appealing in Question #1, and Answer B sounds more appealing in Question #2. The results are irrational, but investors have been known to be illogical too.
In practical trading terms, the application of “Prospect Theory” often manifests itself via the pain principle. Due to loss aversion, investors tend to cash in gains too early and fail to allow their winning stocks to run higher for a long enough period.
The framing of the Kahneman and Tversky’s questions is no different than the framing of political and economic issues by the various media outlets (see Pessimism Porn). Fear can generate advertising revenue and fear can also push investors into paralysis (see the equity fund flow data in Fund Flows Paradox).
Greed can sell in the financial markets too. The main sources of financial market greed have been primarily limited to bonds, cash, and gold. If you caught those trends early enough, you are happy as a clam, but like most things in life, nothing lasts forever. The same principle applies to financial markets, and over time, capital in today’s winners will slowly transition into today’s losers (i.e., tomorrow’s winners).
A healthy amount of fear is healthy, but correctly understanding the dynamics of the “Pleasure/Pain Principle” can turn those fearful tears into profitable pleasure.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including fixed income ETFs), but at the time of publishing SCM had no direct position in GLD, 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.
The Rule of 20 Can Make You Plenty
There is an endless debate over whether the equity markets are overvalued or undervalued, and at some point the discussion eventually transitions to what the market’s appropriate P/E (Price-Earnings) level should be. There are several standard definitions used for P/Es, but typically a 12-month trailing earnings, 12-month forward earnings (using earnings forecasts), and multi-year average earnings (e.g., Shiller 10-year inflation adjusted P/E – see Foggy P/E Rearview Mirror) are used in the calculations. Don Hays at Hays Advisory (www.haysadvisory.com) provides an excellent 30+ year view of the historical P/E ratio on a forward basis (see chart below).
Blue Line: Forward PE - Red Line: Implied Equilibrium PE (Hays Advisory)
If you listen to Peter Lynch, investor extraordinaire, his “Rule of 20” states a market equilibrium P/E ratio should equal 20 minus the inflation rate. This rule would imply an equilibrium P/E ratio of approximately 18x times earnings when the current 2011 P/E multiple implies a value slightly above 11x times earnings. The bears may claim victory if the earnings denominator collapses, but if earnings, on the contrary, continue coming in better than expected, then the sun might break through the clouds in the form of significant price appreciation.
Just because prices have been chopped in half, doesn’t mean they can’t go lower. From 1966 – 1982 the Dow Jones Industrial index traded at around 800 and P/E multiples contracted to single digits. That rubber band eventually snapped and the index catapulted 17-fold from about 800 to almost 14,000 in 25 years. Even though equities have struggled at the start of this century, a few things have changed from the market lows of 30 years ago. For starters, we have not hit an inflation rate of 13% or a Federal Funds rate of 20% (~3.5% and 0% today, respectively), so we have some headroom before the single digit P/E apocalypse descends upon us.
Fed Model Implies Equity Throttle
Hays Advisory exhibits another key valuation measurement of the equity market (the so-called “Fed Model”), which compares the Treasury yield of the 10-year Note with the earnings yield of stocks (see chart below).
Blue Line: 10-Yr Treasury - Red Line: Forward PE (Hays Advisory)
Regardless of your perspective, the divergence will eventually take care of it in one of three ways:
1.) Bond prices collapse, and Treasury yields spike up to catch up with equity yields.
2.) Forward earnings collapse (e.g., global recession/depression), and equity yields plummet down to the low Treasury yield levels.
AND/OR
3.) Stock prices catapult higher (lower earnings yield) to converge.
At the end of the day, money goes where it is treated best, and at least today, bonds are expected to treat investors substantially worse than the unfaithful treatment of Demi Moore by Ashton Kutcher. The Super Committee may not have its act together, and Europe is a mess, but the significant earnings yield of the equity markets are factoring in a great deal of pessimism.
The holidays are rapidly approaching. If for some reason the auspice of gifts is looking scarce, then review the Fed Model and Rule of 20, these techniques may make you plenty.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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.
Winning Coaches Telling Players to Quit
How would you feel if your coach told you not only are you going to lose, but you should quit and join the other team? Effectively, that is what Loomis Sayles bond legend Dan Fuss (read Fuss Making a Fuss), and fellow colleagues Margie Patel (Wells Fargo Advantage Funds), and Anthony Crescenzi (PIMCO) had to say about the chances of bonds winning at the recent Advisors’ Money Show.
This is what Fuss said regarding “statistically cheap” equities:
“I’ve never seen it this good in half a century.”
Patel went on to add:
“By any measure you want to look at, free cash flow, dividend yield, P/E ratio – stocks look relatively cheap for the level of interest rates.” Stock offer a “once-in-a-decade opportunity to buy and make some real capital appreciation.”
Crescenzi included the following comments about stocks:
“Valuations are not risky…P/E ratios have been fine for a decade, in part because of the two shocks that drove investors away from equities and compressed P/E ratios.”
Bonds Dynasty Coming to End
The bond team has been winning for three decades (see Bubblicious Bonds), but its players are getting tired and old. Crescenzi concedes the “30-year journey on rates is near its ending point” and that “we are at the end of the duration tailwind.” Even though it is fairly apparent to some that the golden bond era is coming to a close, there are ways for the bond team to draft new players to manage duration (interest rate/price sensitivity) and protect oneself against inflation (read Drowning TIPS).
Equities on the other hand have had a massive losing streak relative to bonds, especially over the last decade. The equity team had over-priced player positions that exceeded their salary cap and the old market leaders became tired and old. Nothing energizes a new team better than new blood and new talent at a much more attractive price, which leaves room in the salary cap to get the quality players to win. There is always a possibility that bonds will outperform in the short-run despite sky-high prices, and the introduction of any material, detrimental exogenous variable (large country bailout, terrorist attack, etc.) could extend bonds’ outperformance. Regardless, investors will find it difficult to dispute the relative attractiveness of equities relative to prices a decade ago (read Marathon Investing: Genesis of Cheap Stocks).
As I have repeated in the past, bonds and cash are essential in any portfolio, but excessively gorging on a buffet of bonds for breakfast, lunch, and dinner can be hazardous for your long-term financial health. Maximizing the bang for your investment buck means not neglecting volatile equity opportunities due to disproportionate conservatism and scary economic media headlines.
There are bond coaches and teams that believe the winning streak will continue despite the 30-year duration of victories. Fear, especially in this environment, is often used as a tactic to sell bonds. Conflicts of interest may cloud the advice of these bond coaches, but the successful experienced coaches like Dan Fuss, Margie Patel, Anthony Crescenzi are the ones to listen to – even if they tell you to quit their team and join a different one.
Read Full Advisor Perspectives Article
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including TIP), 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.
QE2 Drowning TIPS Yields Below Water
The holiday season is creeping up on us, and the only question building up more anticipation than what gift kids are going to get from Santa Claus is what investors are going to get from Federal Reserve Chairman Ben Bernanke – in the form of QE2 (Quantitative Easing Part II)? The inevitable QE2 program is an effort designed by the Fed to keep interest rates low and reduce the threat of deflation. In addition, QE2 is structured to stimulate the meager 0.8% core inflation experienced over the last 12 months (Bloomberg) to a Goldilocks level – not too hot and not too cold. Some pundits suggest the Fed should target a 2% inflation rate. QE2 asset purchase estimates are all over the map, but I can safely guess somewhere between a few hundred billion and $2 trillion (very brave of me).
Treasuries Weigh Down TIPS Yields
Ever since QE1 expired in the March timeframe, speculation began about the next potential slug of Treasuries and mortgage backed securities to be purchased by the Fed. As a consequence, this speculation became a contributing factor to 10-Year Treasury yields plummeting from around 4.0% to around 2.5%. Simultaneously, 5-Year TIPS (Treasury Inflation Protection Securities) yields have moved to negative territory.
Scott Grannis at Calafia Beach Pundit has a great chart showing the relationship between nominal Treasury yields, real TIPS yields, and expected inflation for 10-year maturities. As you can see below, over the last ten years there has been a tight correlation between the 10-year Treasury bond versus TIPS, with the former 10-year declining yield acting as a weight drowning the latter TIPS yield:
Source: scottgrannis.blogspot.com
Worth noting, absent the brief period in late-2008 and early-2009, inflation expectations have been remarkably stable in that 1.5% – 2.5% range.
Negative Yields…Who Cares?!
Unprecedented times have created an unprecedented appetite for bonds (see Bubblicious Bonds), and as a result, we just witnessed a historic $10 billion TIPS auction this week producing an eye-catching negative -0.55% yield. Sensationalist commentators characterize the negative yield dynamic as a money losing proposition, whereby investors are forced to pay the government. This assertion is quite a distortion and not quite true – we will review the mechanics of TIPS later.
- Source: scottgrannis.blogspot.com
If we’re not back to a panic filled environment of soup kitchen lines and bank runs, then why are TIPS paying a negative yield?
- QE2: As mentioned above, investor expectations are that Uncle Sam will come to the rescue and deliver lower interest rates (higher prices) through purchases of Treasuries and mortgage-backed securities.
- Rising Inflation Expectations: As fears surrounding future inflation increase, the price of TIPS will rise, and yields will fall.
- Sluggish Economy: Lackluster growth and fear of double dips have pressured rates lower as debates still linger about whether or not the U.S. will follow Japan (see Lost Decade).
Nuts & Bolts of TIPS
TIPS maturities come in terms of 5 years, 10 years and 30 years. Per the Treasury, 5-year TIPS are auctioned in April and October; 10-year TIPS in January, March, May (beginning in 2011), July, September, and November; and 30-year TIPS in February and August.
This table from Barclays Capital below does an excellent job of conceptually displaying the differences between vanilla Treasuries and TIPS.
Some Observations:
1) As you can see, the principal value of the TIPS security adjusts with inflation (Consumer Price Index). The price of the TIPS security, which we cannot see in the example, adjusts upwards (or downwards) with inflation expectations.
2) The TIPS security pays a lower coupon (3.5% vs. 5.0%), but you can see that under a 4% annual inflation assumption (principal value adjusts from $10,000 in Year 0 to $10,400 in Year 1), the ending value of the TIPS comes up significantly higher ($19,172 vs. $15,000).
3) The break-even inflation expectation rate is 1.5% (derived from 5% coupon minus 3.5% coupon). If you think inflation will average more than 1.5%, then buy the TIPS security. If you think inflation will average less than 1.5%, then buy the 10-year Treasury.
TIPS Advantages
- Inflation Protection: At the risk of stating the obvious, if you expect long-term inflation to average substantially more than about 2% (current inflation expectations), then TIPS are a great way of protecting your purchasing power.
- Deflation Protection: Perhaps TIPS should be called DIPS (Deflation Income Protection Securities)? What some investors do not realize is that even if our country were to spiral into long-term deflationary crisis, TIPS investors are guaranteed the original amount of principal. Yes, that’s right…guaranteed. Interest payments could conceivably decline to zero and the principal value could temporarily fall below par, but the government guarantees the original principal regardless of the scenario.
- No Credit or Default Risk: The advantage of the government owning its own printing press is that there is very little risk of default, so preservation of capital is not much of a risk.
TIPS Disadvantages
- Interest Rate Risk: It’s great to be indexed to inflation, but because TIPS include long-range maturities, investors face a significant amount of interest rate risk if the TIPS are not held until maturity. TIPS will likely outperform Treasuries under a rising rate scenario, but will be impacted nonetheless.
- CPI Risk: Even if you are not a conspiracy theorist who believes government CPI figures are artificially depressed, it is still quite possible your personal baskets of purchases do not perfectly align with the arbitrary CPI basket of goods.
- Negative Deflation Adjustments: Although a TIPS investor has an embedded “deflation floor” equivalent to original principal value, interest payments will be negatively impacted by declines in principal value during deflationary periods. Also, previously issued TIPS with accumulated principal values from inflationary adjustments run larger principal loss risks as compared to newly issued TIPS.
Although 5-year TIPS yields may have dunked below water into negative territory, the headline bark is much worse than the bite. There has been a massive rally in bond prices in front of the QE2 bond binge by the Fed. Nevertheless, inflation expectations have remained fairly stable and TIPS still provide defensive characteristics under both a future inflationary or deflationary scenario. If the Fed is indeed successful in manufacturing a reasonable Goldilocks range of inflation then TIPS yields should once again be able to come up for air.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including TIP), 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.
PIMCO – The Downhill Marathon Machine
How would you like to run a marathon? How about a marathon that is prearranged all downhill? How about a downhill marathon with the wind at your back? How about a downhill marathon with the wind at your back in a wheelchair? Effectively, that is what a 30-year bull market has meant for PIMCO (Pacific Investment Management Co.) and the “New Normal” brothers (Co-Chairman Bill Gross and Mohamed El-Erian) who are commanding the bond behemoth (read also New Normal is Old Normal). Bill Gross can appreciate a thing or two about running marathons since he once ran six marathons in six consecutive days.
This perseverance also assisted Gross in co-founding PIMCO in 1971 with $12 million in assets under management. Since then, the company has managed to add five more zeroes to that figure (today assets exceed $1.2 trillion). In the first 10 years of the company’s existence, as interest rates were climbing, PIMCO managed to layer on a relatively thin amount of assets (approximately $1 billion). But with the tailwind of declining rates throughout the 1980s, PIMCO’s growth began to accelerate, thereby facilitating the addition of more than $25 billion in assets during the decade.
The PIMCO Machine
For the time-being, PIMCO can do no wrong. As the endless list of media commentators and journalists bow to kiss the feet of the immortal bond kings, the blinded reporters seem to forget the old time-tested Wall Street maxim:
“Never confuse genius with a bull market.”
The gargantuan multi-decade move in interest rates, the fuel used to drive bond prices to the moon, might have something to do with the company’s success too? PIMCO is not exactly selling ice to the Eskimos – many investors are scooping up PIMCO’s bond products as they wait in their bunkers for Armageddon to arrive. Thanks to former Federal Reserve Chairman Paul Volcker (appointed in 1979), the runaway inflation of the early 1980s was tamed by hikes he made in the key benchmark Federal Funds Rate (the targeted rate that banks lend to each other). From a peak of around 20% in 1980-1981 the Fed Funds rate has plummeted to effectively 0% today with the most recent assistance coming from current Fed Chairman Ben Bernanke.
Although these west-coast beach loving bond gurus are not the sole beneficiary in this “bond bubble” (see Bubblicious Bonds story), PIMCO has separated itself from the competition with its shrewd world-class marketing capabilities. A day can hardly go by without seeing one of the bond brothers on CNBC or Bloomberg, spouting on about interest rates, inflation, and global bond markets. As PIMCO has been stepping on fruit in the process of collecting the low-hanging fruit, the firm has not been shy about talking its own book. Subtlety is not a strength of El-Erian – here’s what he had to pimp to the USA Today a few months ago as bond prices were continuing to inflate: “Simply put, investors should own less equities, more bonds, more global investments, more cash and more dry ammunition.”
If selling a tide of fear resulted in a continual funnel of new customers into your net, wouldn’t you do the same thing? Fearing people into bonds is something El-Erian is good at: “In the New Normal you are more worried about the return of your capital, not return on your capital.” Beyond alarm, accuracy is a trivial matter, as long as you can scare people into your doomsday way of thinking. The fact Bill Gross’s infamous Dow 5,000 call never came close to fruition is not a concern – even if the forecast overlapped with the worst crisis in seven decades.
Mohamed Speak
Mohamed El-Erian is a fresher face to the PIMCO scene and will be tougher to pin down on his forecasts. He arrived at the company in early 2008 after shuffling over from Harvard’s endowment fund. El-Erian has a gift for cryptically speaking in an enigmatic language that could only make former Federal Reserve Chairman Alan Greenspan proud. Like many economists, El-Erian laces his commentary with many caveats, hedges, and generalities – concrete predictions are not a strength of his. Here are a few of my favorite El-Erian obscurities:
- “ongoing paradigm shift”
- “endogenous liquidity”
- “tail hedging”
- “deglobalization”
- “post-realignment”
- “socialization losses”
Excuse me while I grab my shovel – stuff is starting to pile up here.
Don’t get me wrong…plenty of my client portfolios hold bonds, with some senior retiree portfolios carrying upwards of 80% in fixed income securities. This positioning is more a function of necessity rather than preference, and requires much more creative hand-holding in managing interest-rate risk (duration), yield, and credit risk. At the margin, unloved equities, including high dividend paying Blue Chip stocks, provide a much better risk-adjusted return for those investors that have the risk tolerance and time-horizon threshold to absorb higher volatility.
PIMCO has traveled along a long prosperous road over the last 30 years with the benefit of a historic decline in interest rates. While PIMCO may have coasted downhill in a wheelchair for the last few decades, this behemoth may be forced to crawl uphill on its hands and knees for the next few decades, as interest rates inevitably rise. Now that is a “New Normal” scenario Bill Gross and Mohamed El-Erian have not forecasted.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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 PIMCO/Allianz, 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.
September Surge: Stop, Go, or Proceed Cautiously?
The stock market just posted its strongest September and third quarter performance in more than seven decades (S&P 500 +8.8% and +10.7%, respectively), yet people are still waiting for a clear green light to signal blue investment skies ahead. Well of course, once it is apparent to everyone that the economy is obviously back on track, the opportunities persisting today will either be gone or vastly diminished. I’m not a blind optimist, but a sober realist that understands, like Warren Buffett, that it pays to “buy fear and sell greed.” And fear is exactly what we are witnessing today. The $2.6 trillion sitting in CDs earning a horrendously low 1% is simple proof (Huffington Post).
Like the fresh memory of a recent hand burned on the stove, the broader general public is still feeling the pain and recovering from the financial crisis. Each gloomy real estate or unemployment headline triggers agonizing flashbacks (read Unemployment Hypochondria) of the 2008-2009 financial collapse and leads to harmful emotional investment decisions. However, for some of us finance geeks that have cut through the monotony of “pessimism porn” blasted over the airwaves, we have discovered plenty of positive leading economic indicators bubbling up below the surface, like the following:
- Continued Economic Growth: Gross Domestic Product (GDP) grew +1.7% in the second quarter and current estimates stand in the +2.0% to +2.5% range for third quarter GDP, which will mark the fifth consecutive quarter of growth.
- Growing Corporate Profits: S&P 500 earnings are estimated to expand by +45.6% in 2010 and are estimated to grow by another +15% or so next year (Standard & Poor’s September 2010).
- Escalating M&A: Mergers and acquisitions activity increased to $566.5 billion in the third quarter. The value of announced transactions is up +60% from a year ago according to Bloomberg. If you have a tough time comprehending the pickup in M&A, then take a peek here.
- Record Cash Piles: The top 1,000 largest global corporations held a whopping $2.87 trillion in cash (Bloomberg).
- Accelerating Share Buybacks: Share buybacks totaled $77.6 billion in the second quarter, up +221% from a record low last year – Barron’s).
- Dividends Galore: S&P 500 companies have lifted their payouts by $15 billion so far this year versus a reduction of $40 billion for the same period last year (The Wall Street Journal). Tech giant Cisco Systems Inc. (CSCO) announced the pending initiation of a dividend, while Microsoft Corp. (MSFT) increased its dividend by a significant +23%.
I’m not naïve enough to believe choppy waters will disappear for good, but despite the depressing headlines there are constructive undercurrents. Beyond the points above, equity market prices remain attractive relative to the broader fixed-income markets (see Bubblicious Bonds) . More specifically, the S&P 500 is priced at about a 25% discount to historic valuation averages over the last 55 years (currently trading at about 12.5 Price/Earnings ratio vs 16.5x historic Price/Earnings ratio – Bloomberg). Now may not be the time to recklessly run a red light, but if you fearfully remain halted in front of the green light then prepare to receive a pricey ticket.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and CSCO, but at the time of publishing SCM had no direct position in MSFT, 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.
Siegel & Co. See “Bubblicious” Bonds
Source: Wall Street Journal - March 14, 2000
Siegel compares 1999 stock prices with 2010 bonds
Unlike a lot of economists, Jeremy Siegel, Professor at the Wharton School of Business, is not bashful about making contrarian calls (see other Siegel article). Just days after the Nasdaq index peaked 10 years ago at a level above 5,000 (below 2,200 today), Siegel called the large capitalization technology market a “Sucker’s Bet” in a Wall Street Journal article dated March 14, 2000. Investors were smitten with large-cap technology stocks at the time, paying balloon-like P/E (Price-Earnings) ratios in excess of 100 times trailing earnings (see table above).
Bubblicious Boom
Today, Siegel has now switched his focus from overpriced tech-stock bubbles to “Bubblicious” bonds, which may burst at any moment. Bolstering his view of the current “Great American Bond Bubble” is the fact that average investors are wheelbarrowing money into bond funds. Siegel highlights recent Investment Company Institute data to make his point:
“From January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.”
The professor goes on to make the stretch that some government bonds (i.e., 10-year Treasury Inflation-Protected Securities or TIPS) are priced so egregiously that the 1% TIPS yield (or 100 times the payout ratio) equates to the crazy tech stock valuations 10 years earlier. Conceptually the comparison of old stock and new bond bubbles may make some sense, but let’s not lose sight of the fact that tech stocks virtually had a 0% payout (no dividends). The risk of permanent investment loss is much lower with a bond as compared to a 100-plus multiple tech stock.
Making Rate History No Mystery
What makes Siegel so nervous about bonds? Well for one thing, take a look at what interest rates have done over the last 30 years, with the Federal Funds rate cresting over 20%+ in 1981 (View RED LINE & BLUE LINE or click to enlarge):
Source: dshort.com
As I have commented before, there is only one real direction for interest rates to go, since we currently sit watching rates at a generational low. Rates have a minute amount of wiggle room, but Siegel rightfully understands there is very little wiggle room for rates to go lower. How bad could the pain be? Siegel outlines the following scenario:
“If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield.”
Siegel is not the only observer who sees relatively less value in bonds (especially government bonds) versus stocks. Scott Grannis, author of the Calafia Report artfully shows the comparisons of the 10-Year Treasury Note yield relative to the earnings yield on the S&P 500 index:
Source: Calafia Report (Scott Grannis)
As you can see, rarely have there been periods over the last five decades where bonds were so poorly attractive relative to equities.
Grannis mirrors Siegel’s view on government bond prices through his chart on TIPS pricing:
Source: Calafia Report (Scott Grannis)
Pricey Treasuries is not a new unearthed theme, however, Siegel and Grannis make compelling points to highlight bond risks. Certainly, the economy could soften further, and trying to time the bottom to a multi-decade bond bubble can be hazardous to your investing health. Having said that, effectively everyone should desire some exposure to fixed income securities, depending on their objectives and constraints (retirees obviously more). The key is managing duration and the risk of inflation in a prudent fashion. If you believe Siegel is correct about an impending bond bubble bursting, you may consider lightening your Treasury bond load. Otherwise, don’t be surprised if you do not collect on another “sucker’s bet.”
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including TIP and other fixed income ETFs), but at the time of publishing SCM had no direct position in any 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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