The 10-2 Indicator Says No Recession, Market Collapse

A popular indicator is the 10 Year Treasury yield less the Two Year Yield.  When the number is positive or upward sloping, that is typically indicative of a growing economy.  The short version is that the Fed heavily influences the short-end of the curve, so when investors are confident about the economy they sell the long-bond pushing the yield up. 

Now the Fed can and will, as evident by quantitative easing (the Fed buying longer dated bonds), control the long-end too.  Thus, even though we have an upward sloping curve now there is still some heavy Fed influence as they are keeping short-term rates very low.  Further, the drawing down of quantitative easing (no longer buying longer dated bonds) expected Q1 next year should push up the long-end of the yield curve.

Still, even with that caveat I found the chart below pretty fascinating.  The blue line is the 10 Year yield less the 2 Year yield and the red line is the S&P 500.  

A few things stick out:

1. A negative sloping yield curve has ALWAYS led to a recession.  There all no false positives.
2. We have never had a recession since 1976 (from when the data was available) where the yield curve did NOT turn negative beforehand.
3. The last two major markets tops in 2000 and 2007 coincided with a negative yield curve.
4. We don’t have anything close to a negative curve now.  In fact, the slope is moving higher.  

While the sample size is small and everything works until it doesn't, it bares extremely well for the economy.  This has important stock market implications.  I have noted before that even if earnings lag (say the economy is weaker than expected or the record high profit margins come down) we can still have multiple expansion to push the market higher given short-term valuations are not at extreme levels.  That isn't to say the market can’t or won’t have a hiccup or pullback around 20% or so, just that a larger bottom doesn't appear to be in the cards unless that 10-2 indicator reverses. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Can Deflation Stop the Rally?

Will deflation doom stocks?  If prolonged logic dictates it will.  Lower cost = lower earnings = lower prices AND higher real rates = good alternative to stocks = lower valuations.  This is why looking at the latest CPI numbers it’s at least a tad concerning:

The chart shows disinflation and is getting worse -- see the arrow.  Currently inflation is running a little under 1%; thus, we are currently not in deflation, but disinflation.  An article in FT highlights the concern moving forward:

“’The lesson of the past, [CLSA], is that the three previous times the US rate of inflation dropped below 1 per cent since 1957 — 1998, 2001-02, and 2008-09 — stock market investors suffered significant losses.’ … 

In 2002, during the period when Ben Bernanke made his infamous helicopter money speech, stocks fell by almost a third after US inflation dropped below 1 per cent. 

Also, in 2008, inflation fell through that 1 percent line days before Lehman Brothers filed for bankruptcy.”

I decided to dig a bit deeper and put together my own data table – here.  I was looking for points in time when inflation for all items (there appeared to be little link between inflation ex. food and energy) was lower than both our current level of inflation and subsequent one year returns.  Here is the summary:

To me the data and subsequent analysis shows the following:

• First there is a small sample size, so certainly findings should be taken with a grain of salt.
• Returns are lower and the probability of a negative return over the next 12 months is elevated.
• But the lowest return, while large, still isn’t a bear market and I wouldn’t consider it catastrophic, especially with diversification and risk control.
• And there are still positive returns with some large ones even.
• What’s also interesting is the negative correlation (lower inflation number = higher forward returns), which on the surface seems counter intuitive…
• Until you take into account that as these numbers worsen the Fed will ease more and thus provide a bump to the markets.
• When you look at the 2009 data, this illustrates that.  The big fall in the market coincided with disinflation/deflation; however, once we fell below 1% the 12 month forward returns on the S&P were all positive.
• Thus, my view is even if disinflation persists, based on recent history the Fed will step up and pump up the inflation number, and subsequently the market.  Now if the Fed doesn’t step up or their efforts no longer work, then the risk of negative returns on stocks is elevated.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

By Definition, Black Swans Can’t Go Away

If everyone can quantify the risk that the world will burn, then if it goes up in flames it’s now allowed to count as a black swan (or blind tail risk) event. 

The term black swan, made famous by Nassim Nicholas Taleb, refers to a phrase from a time London when they wore funny clothes, and powdered wigs.  At the time everyone thought a swan was white, thus a black swan was viewed as impossible or at least improbable.  Without getting too philosophical, the phrase refers to risk to which the consensus is totally blind, either because their premise or their process is wrong.  Basically a black swan risk is a huge catastrophic risk not many see coming - the unknown unknowns (i.e. we don’t know the risk or the outcome).

As outlined by Business Insider, large scale risks are off the table in 2014:

“Betting against a U.S. financial collapse was a great call. Betting against a Eurozone crash was a great call. Betting against a Chinese hard landing that threatened the whole world was a good call. Betting against a debt ceiling default was the right call.”

Those assessments were totally correct.  Further, the risks of those events moving forward have been substantially diminished; however, those were all known unknowns (i.e. we knew the risk, but not the outcome).  A common misconception is that risks like the aforementioned are black swan events: they are not, and the reason is the consensus at the very least saw these coming head on.  On the surface this seems like a debate in semantics, though it’s more practical to one’s portfolio than that. 

While it’s true those aforementioned risks are now less likely than before, as the article points out the market has probably priced that in by now.  Thus, our conversations with clients on risk are shorter, our bullish thesis is stronger, and our asset allocation observations are lower on conditionals (e.g. stocks will have a good year if various European countries don’t replay the French Revolution). 

Therein lies the issue, investors are now more confident that those large scale risks are diminished.  This is true for what everyone can see, but can NEVER be true for actual black swan events.  Further, as the known risks seem to evaporate the probability of being oblivious to a true blind tail risk event inherently becomes greater.

All of this is a nice way of saying be prepared for anything, never be too strong in your investment convictions, or dismiss anything outright.  The ways to accomplish this are through proper diversification, discipline, the use of out-of-the-money put options, and other prudent risk management techniques.  This is also why I have been bullish, but never omniscient.    

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Getting Fresh with the Markets – Part 2

While I highlighted JP Morgan’s sexy charts in my last post, now it’s time for my sexy charts.  It’s really a whole document, which you can find uploaded here. 

Aside from being more colorful and handsome, my weekly charts attempt to capture the movements of multiple markets, how they are performing relative to other markets, and if they are more risky based on a historical metric I use, among other data.  In short, I use it to identify trends in broad based ETFs, so that we can apply that to our portfolio construction, accordingly.

So here is a quick summary based on weekly data at the close of November 15^th and monthly data as of October 31^st: 

• It’s really amazing how the risk indicator has worked with domestic investment grade bonds.  In October bonds rallied but failed to pierce the risk indicator.  Since then bonds have moved down; though, did rally last week.
• And bonds have by and large had a positive return over the last 12 weeks.
• Another thing to note is the AGG (Aggregate Bond US Bond Index) chart.  Look at that fall!  But how much is AGG down over the last year?  -1.71%.  So really not that big of a deal in my mind.  To me this indicates that even in rising interest rate environments (when interest rates rise bond prices fall), there is little risk of huge portfolio loss from holding bonds.
• Note, the duration (a measure of a bond’s sensitivity to interest rate changes) of the AGG is still under 5, so it’s not like there is huge interest rate risk holding AGG.  This is different for longer dated bonds though.
• Munis still continue to suck wind against corporates, despite their recovery over the last 3 months.
• High yield has been relatively immune to the rise in interest rates.  This isn’t surprising as high yield is usually negatively correlated with Treasuries. 
• A recent trend of late is the outperformance of SPY (large caps) vs. IWM (Small Caps), which are actually flat over the last month.  I wonder if this is the sign of a tired rally as typically riskier flare leads.
• Alternatively, Growth has outperformed Value over the last few months, which may be a short-term move, but is a directional change at least for the time being.
• Developed Market stocks are up, but are still underperforming SPY over the past 12 months (and every other period listed).
• Emerging Market stocks are all over the place.  I love their valuation, but to me still seems like the trend is against them.
• Commodities in general seem to be consolidating, though Oil looks could be in a downtrend.
• The same goes for Real Estate.  In my opinion, rising rates are probably more hazardous to IYR (Real Estate ETF) than to AGG.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Getting Fresh with the Markets – Part 1

I have mentioned this before, but JP Morgan’s Guide to the Markets is really full of awesome charts, graphs, and data.  The edition for Q3 (note all data as of 10/31) can be found here.  Below are some of things I found of interest and how they affect your portfolio:

• From the market bottom in March 2009, the S&P 500 is up 174% and 23% above the prior 2007 peak.
• Best sector YTD is Consumer Discretionary, which is bullish given its cyclical nature.  Further, it’s trailing and forward PEs are still below historical norms.
• Most valuation levels on the markets seem reasonable, thus it doesn’t seem that valuation will dislodge the rally.  Though there is the exception of Shiller Price to Earnings Ratio, but even he admits this isn’t a short-term metric.
• One big market worry is profits as a % of GDP.  This is at an all-time high.  So if this reverts and profits are hurt this could affect the market or on the other hand valuations could keep rising.  This undoubtedly ties to the poor employment picture.
• Interesting to note that when yields are below 5% and interest rates go up, generally stock prices have a positive return.
• Corporate balance sheets are very strong with higher % of cash and lower % of leverage.
• The earnings yield is the reverse of the P/E ratio, in other words, earnings divided by price: by this measure, the markets are cheap.  Further, even if we get to the average valuation level on the earnings yield ration markets have historically followed with positive moves.
• Consumer balance sheets are improving and debt payments as a % of personal income look to be close to an all-time low.  The household deleveraging cycle may be over, and consumers may begin to have disposable income, something which the economy has missed dearly.
• To me employment still looks ugly. Much of the drop in the unemployment rate is a result of people dropping out of the work force. On the other side of that equation, I also read elsewhere the following: if all 3M open positions in the US were filled, unemployment would drop into the mid 4% range. This is largely due to a skills gap.
• Inflation as reflected by the CPI is still tame, so the Fed is really under no pressure, and can be accommodative, which is bullish for stocks.
• Our oil imports our dropping, though we are the largest consumer.  We also produce 12% of the world’s oil, second only to Saudi Arabia, and are expected to surpass them in 2015.
• Looking at the long-run chart on interest rates, it’s tough to tell if we have bottomed.  Though I will say on a subjective note that the current interest rate move up has felt different. 
• While the spread (the difference between two bonds with similar maturity) on high yields makes them look rich, municipal bonds look attractive. 
• While domestic stocks have blown through their 2007 peak, Developed and Emerging Market stocks have not.  This indicates that while the trend still favors the US, on the long-term basis these markets might be more attractive.  Emerging Markets in particular; however this was the case last year at this time, and those who made that bet – we didn’t – have been very disappointed this year.
• Consumption in Emerging Markets is on the rise while US consumption is falling.  This is good for a more balanced world economy.
• Europe still has some gaudy unemployment numbers, particularly in Spain and Greece where they eclipse 20%.
• US stocks have crushed every broad asset class YTD.
• 2013 should be the first year since 2005 since domestic equity funds will have positive fund flows.  Glass half full - more flows from retail investors can push the market higher.  Glass half empty -- retail investors don’t really move the market as evidenced by negative flows since 2009 despite a huge bull market. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

30 Minutes to Understand the US Economy

I cheated this week and am making one longer commentary, as opposed to two shorter ones.  This is due to my own personal time crunch, and the depth required for this subject.

Further, I am using Google Docs. for the deeper dive into this piece, and can be accessed here.    What is contained there is my summary notes of the 30 minute embedded video Ray Dalio put together entitled “How the Economic Machine Works”. 

Dalio runs the world’s largest hedge fund, the $120B Bridgewater Associates. This is the most simple and succinct explanation of how money and credit are used in transactions, the sum of which is our economy: why we have booms and busts, where we are at in the current cycle, what’s likely to happen moving forward, etc.  Dalio boils this all down to the most basic fundamentals, and makes everything easy to understand.

While I don’t believe these views are mainstream economic thought, they are much in line with my beliefs on how the economy works, and provides a practical means to explain what has happened in the past.  Those who follow a similar viewpoint have been right more often than their peers.  So click the link, use my outline to follow along, and in 30 minutes, you will better understand what makes our economy tick and destroy those who challenge you at cocktail parties.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Buy and Hold Works, But May Not Be For Everyone

I believe the above stampede was engineered by a few hyenas at the behest of Scar in an attempt to kill the king, Mufasa, and his son, Simba.  While the Lion King certainly is not a film about investing, I do think the stampede scene illustrates what I believe to be a fundamental truth about investing – fear leads many to run for the exits all at once.  This undoubtedly is a horrible strategy, and the herd is guilty of buying at the top and selling at the bottom.

The way to avoid this is to build a diversified portfolio, dollar cost average into riskier assets (i.e. spread your purchases over time), and only look at it on occasion.  Almost everyone can do one and two, but the problem lies with #3.  Almost nobody can put their money aside and not look at it.  And if you can’t, chances are you will worry about it from time to time.

Certainly there is nothing wrong with worrying about your money.  In fact I believe worrying, if properly directed, leads to prudent asset management causing the investor to focus on risk as the primary driver of asset allocation.  However, when worry turns to fear and panic, it leads to catastrophe.

We recently met with a very large investment management company, who wanted to pitch us on their investment process.  It had a lot of merit: essentially they skew their investments to assets that have historically outperformed the market.  The issue is that they expected (really almost require) us to hold their investments through up markets and down markets, regardless whether we felt it was prudent for our client to liquidate given their risk level. 

They use a lot of data and numbers to tell their story and wanted us to “teach” our clients how to invest – buy and hold these asset classes until the end of time.  My issue isn’t with their style or their numbers, but they fail to realize an essential fact: when markets are in their darkest hours many investors aren’t built to handle that pain and need to abandon ship, which typically happens to be at the worst possible time.

So how can we as wealth managers prevent our clients from doing this?  The best way is to know your client. This approach will lead to suitable, diverse, portfolio construction, which should minimize portfolio draw downs.  This strategy and discipline should prevent a wholesale sell off for the very risk averse clients. While we aren’t selling at the bottom, we are certainly paring back the risk as markets decline, which by the way is another method to avoid the herd mentality and the risks associated with it.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

So What, Who Cares

I have been willfully ignorant of whatever is going on in Washington. When I do hear snippets here and there on Bloomberg I want to do this:

If I listen at this point it will only be a detriment to prudent wealth management:

• T = 0: Self-inflicted issue (e.g. the debt ceiling) that could have a “catastrophic” impact on the markets and the economy starts being chatted about in investment circles

• T = 1: Self-inflicted issue begins to pick up steam as a “legitimate” threat; markets largely ignore

• T = 2: Politicians dig in and hope for a comprise is lost; markets pick up volatility

• T = 3: Now the only thing that will save us is a last minute deal; market moves down a few percent, not enough for me to put cash to work and buy (annoying), but also not triggering any sell signals for existing holdings

• T = 4: At the last minute whichever party is losing the popularity poll caves; market back to where it was before

• T = 5: Self-congratulating politicians save the world from a problem they created; everyone vomits

• T = 6: For real?  Those insufferable mutants only kicked the can down the road, again not solving their own problem

• T = 7: Wait until we get to do this same charade all over again

I am fairly sure the above blueprint can be written in stone.  Thus, if you care to tune out Washington like I do then take a nap for a month and that’s where we will be.

Note: The Debt Ceiling talks of August 2011 coincided with a near collapse in Europe, thus the almost 20% decline in the markets doesn’t count.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Nothing New, Except my ACL

I apologize for the recent lack of posts.  I had knee surgery last week, and my absence is the result of prepping and recovery. I had really expected to be able to blog during the first week of recovery since I am a seasoned veteran of ACL surgery: this is my third; however, this time included more extensive work, and that didn't turn out to be the case. In fact as I write this I am still out of the office with limited mobility, with five more weeks on crutches.  In short, I hate my knees.

The markets must have detected my absence, as my hiatus hasn't yielded any real news of note.  This isn’t surprising, of course.  Here are 10 things that appear to be roughly the same as a few weeks ago.

1. Domestic equity markets are at roughly the same place.
2. Yields are still much higher than they were earlier in the year, though have seen a noticeable change since I've been gone.  
3. The Fed is still contemplating to taper or not to taper its bond purchases. 
4. Economic data has been expansionary.  
5. Syria, still in a Civil War.  No action taken.  But maybe.
6. The Government may did shutdown. This may be resolved postponed, etc. by the time of the post.  My guess is there will be kicking and screaming and right before it’s about to matter whichever party is losing the PR battle will cave.
7. There is also the debt ceiling too.  (See resolution to shutdown).
8. Emerging Market stocks are still attractively valued.
9. Europe is still Europe. 
10. One Big Change: Cleveland sports in the aggregate are no longer the national punching bag.  If Jacksonville counts, I think they win that distinction.

Frankly, most two week spans are strikingly similar:

1. Dominant trends tend to play out over longer periods of time.Thus, items that are worthy of attention tend not to change overnight and stories that are mostly noise self-reinforce to produce more noise.  
2. Seldom does any of this news require immediate reaction, in fact responding to new data without quality analysis often backfires.
3. While this lack of movement is boring, it bodes well for those of us who are off the grid for a while, either by choice or for ACL replacement.

I need to get caught up and back up to speed this week, but you can expect regular, roughly bi-weekly posting to resume later this week or next week.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Interest Rates Rise, Other Assets Moves

The 10-Year bond is almost at 3%, which pretty incredible as in early May it stood at 1.63%.  Depending on your time frame, this is one of the larger moves of all-time:

Since interest rates affect every other asset class and the economy, let’s see how this rise has filtered through and the possible reasons why:

• Emerging market assets have gotten crushed - See India.  Reason:  Investors move out of higher yielding emerging market assets as they now have a higher rate of interest here.  As assets move out, their central bank has to sell Treasury Bonds to accommodate currency flows, reinforcing the problem.

• Mortgage rates are up big - Reason:  Fed tapering includes Fannie and Freddie bonds, which are pooled mortgages.  Less demand via Fed and the market (given the Fed’s move) means higher interest rates on those bonds and the subsequent mortgages tied to them.

Note:  Interest rates rise and bond prices fall.  If there is less demand then the price will fall, thus equating to higher interest rates.

• Real Estate in general hasn’t fared too well - See Homebuilders and REIT ETFs.  Reason:  Higher interest rates = higher mortgage rates (see #2) = higher cost of purchasing a home = less demand.

• Stocks are up - See SPY.  Reason:  Fed’s taper and economic data indicates improving (slightly) economy > higher revenues > higher earnings.  This is a positive change, as in the recent past there have been times where weak data has meant more easing, lower rates, and higher equities. 

Of course other markets are moving, this is just a snapshot. Yet, the following presents the most interesting questions moving forward:

At what point do rising interest rates, or the pace of that rise, compress earnings given higher borrowing costs and lower consumption?  Alternatively, will the economy improve enough to cancel out the earnings hit?  If not, will the Fed un-taper?

While the debt ceiling, government shutdown, Syria, etc. will take all the headlines, to me rising rates and how they filter through the economy are the biggest risks moving forward.  

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Stocks out of Retail’s “Circle of Trust”

I remain unconvinced retail investors have let equities back into their circle of trust.  An easy way to see this is through mutual fund flow, because mutual funds are predominantly owned by retail investors.  This chart from JP Morgan (through May 2013) illustrates this:

I should note, other charts from Goldman Sachs show a similar trend through mid-August.  Point being, retail investors have been selling throughout most of the rally, and appear to be adding those funds and some cash to bonds. 

But what we haven’t seen yet, even this year where bonds have been under pressure, are retail investors selling those bonds and moving them into equities.  It appears most of fund flows are coming from the money markets.

Glass half full: this rally, which started in 2009 can have more steam if retail rotates into equities from money markets or bonds.  Glass half empty: retail is permanently scarred from the financial crisis, and stays on the sidelines.  I tend to think it’s more the former, but this chart gives me pause:

Even with the equity markets up nicely for the year, at the first sign of a minor pause, retail heads for the exit.  So, while the trend is positive…

Scars of ’08 and ’09 still haven’t healed to the point where we can say convincingly that it is sustainable.  But if that happens, this bull market could have some legs.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

The Doomsday Portfolio Strategy

Building a castle to protect against end of times.  That is the premise of a new reality show:

I have no doubt this guy and his family will be better prepared than I for societal collapse.  I also have no doubt his opportunity cost (i.e. the value of the alternative given up in pursuit of building a castle) is astronomical.  This is amplified by the extraordinarily low likelihood of a situation where a concrete castle complete with sharp shooter, a catapult, archer posts, etc. is required for survival.

Bringing this back to investing, a profitable trade is one that essentially sells the end of capitalism and democracy as we know it.  Profitable is italicized as the profitability is for whoever is selling the trade, not the investor actually putting capital to work.  Fear sells, the more extreme the better.

This trade can be take various forms - Treasury bonds crash, the Dollar collapses, equity markets cease to trade, etc. - and is almost always followed by a claim of certainty by the seller.  Much of the pitches I have seen and heard involve “structuring your portfolio for the inevitable XYZ.”  This can come at a substantial opportunity cost to the investor (a good example is the omnipresent and immediate inflation, which is just around the corner, and has been predicted since 2008).

Technical issues aside, I find the central issue many of the doomsday traders fail to recognize is that most people in our society want a better world.  They enjoy their lives relative to the alternative chaos.  Thus, even if all points are reasonable (side note, surprise they never are) nearly everyone is comfortable believing the status quo even it’s a lie is far better than living in a cave.

Much of this is semantics, and while a certain trade may not end in society imploding there certainly is a risk that a portion of it will play out.  Still, instead of gearing your total portfolio to capitalize on the unlikeliest of outcomes, it would make much more sense to maintain the present course and buy deep-out-of-the-money options on assets that would benefit should something resembling your own personal doomsday scenario play out.  That way you keep your opportunity cost low and feed your disaster beast.

Lastly, take any doomsday scenario an investment professional is selling and take it to the end game.  For instance, if the dollar collapses and everyone is running for the high ground does it matter how your portfolio performed?  Of course not.  I’d rather have a doomsday castle.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Emerging Markets Equities Get No Love: Pics, Charts, Graphs

Chances are you haven’t liked investing in Emerging Markets for the last 5 years:

As the red-headed equity step-child, Emerging Markets have been extraordinarily disappointing.  Global Fund Managers haven’t taken too kindly to this performance, and have decided to put less and less dollars there:

The good news is since Emerging Market equities have been loathed nearly as much as A-Rod they are now attractively priced:

JP Morgan

In fact, the case can be made Emerging Market equities offer better forward return prospects than any other equity asset class.

GMO

So is now the time to buy?  It could be.  But I want to see the markets validate this before I make any overweight recommendations.  Market trends can persist for a long-time, both on the way up and on the way down.  Thus, my current Emerging Markets Equity Strategy:

Current Market Scorn + Attractive Valuations = Wait for Trend Reversal + Then Start to Build an Overweight Position.

This way (in theory) I can insulate myself from the “falling knife” and still capture a decent chunk of the upside.  That could be next month or next year, but whenever it is the returns of that asset class should be attractive on a risk/reward basis.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Perspective on the Recent Bull Move: Just Where Are We in This Cycle?

Almost everyone is happy as Diamond Dave when stocks go up.  Luckily, that has been mainly the case since 2009, despite the fact that it has felt better looking back, and investors have been nervous the entire time.   It’s helpful to look at similar past moves, not necessarily as a guide, but to see where we currently stack up in terms of duration and size and maybe see if a chart pattern stacks up. 

The former lets me know there is juice left in the squeeze.  While past moves don’t provide absolute certainty, historical precedent provides trends and perspective.  The latter is a guide to how investor emotions tend to move throughout a cycle.

For instance, while the current bull market run is large in both size and duration there have been moves in the past that have lasted longer.  This tells me that despite some clamoring the current market run is due for a reversal (and it may be), past moves have indicated that such a move can go on for quite some time. 

Here is a chart from Merrill Lynch and noted by Barry Ritholtz:

So here is how I see it:

• In terms of duration and length, the current bull market is roughly in the middle.  Thus, while long in the tooth, history suggests the market still can run more.
• Twice after a similar rally we have started a new secular bull market after a 20% pullback. (Merrill Lynch note)
• However, twice we have had large time periods of range bound markets after the 20% pullback. (Merrill Lynch note)
• In short, a pullback while inevitable doesn’t have to happen tomorrow and once it does happen it could either be a nice long uptrend for equities or the start of a more range bound market. 
• So what this really tells us is that are a still wide range of outcomes, even after our large bull market run.

Thus, I still think the prudent move is to let the market run, while staying up the quality chain and looking for signs of deterioration, something I will cover in a future blog.  At that point, pairing back risk exposure will be the sensible move.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Why Everyone is Worried About Fixed Income Risks And How To Address It

Client questions present the best blog post opportunities.  There is no better sample of what is going on in the minds of high net worth investors.

Recently, a client asked us to comment on the latest piece from PIMCO’s Bill Gross, which he read in a national publication.  Below is an abridged version of my response, which outlines various themes, risks, and subsequent strategies to fixed income moving forward: 

• The initial theme of the August Outlook is “there will always be a need for fixed income”.  I totally agree.  In fact, I would say the demand on the private individual side will increase over time.  This is due to the demographic change we will be going through, e.g. an aging population.
• Also, Treasury supply may fall as the budget deficit falls.
• I explained that it would be helpful to look at this client’s own situation.  In this case, we are managing the portfolio to withstand a large loss of capital.  Of course we can’t protect against any or all loss, but we can build the portfolio to try and avoid the big losses: in effect, win by not losing big.  Bonds are still the best way to do that, and the chart below provides historical evidence:

• One could retort that yields have been falling for almost this entire period; thus, bond prices rise. This is true; however, from 1976 to late 1981 bond yields on the 10 year treasury doubled (thus bond prices fall), going from roughly 8% to 16%. 
• Further, the max drawdown over a rolling 12 month period was -9.20% for bonds and if you held them for 5 years the low return would be 11%.  Thus, even over a 5 year period where interest rates on the 10 Year Treasury doubled, aggregate returns for the asset class were positive. 
• Even with the recent spike in interest rates, the largest on record for a similar time frame, most of our bond managers range from down 3% to up 1%.  This is hardly the big loss I mentioned earlier.
• I also contend high quality bonds will still offer the greatest hedge against falling risky assets.  Thus, the small loss we experienced on the bond side was still worth it given the protection it provides if equity markets reverse course.
• The reason aggregate bond returns can still be positive even as Treasury rates rise (aside from coupon payments) is due to the other major theme of the Gross piece – carry (another way to say yield, but more than a fixed coupon payment).  He lists 5, but I will focus on two:   

1. One way to add carry is through credit spreads, which is the difference between what one type of bond yields and a Treasury bond yields (note: they both have the same duration, or to make it easier, maturity date).  In this instance, even when Treasury yields rise if spreads don’t rise (and they typically don’t) the investor still has a positive return.  Given the large amount of bond asset classes, there are usually opportunities in one asset class or another to add carry via the credit spread.  And at various points some bond asset classes or more advantageous than others.
1. A good example is a high yield bond, because the risk of default is substantially higher than that of a Treasury investors receive a higher yield.  Assuming the risk of default is low (e.g. when the economy is good), even when Treasury rates rise these bonds can generate a positive return as their interest rates may stay the same or fall (i.e. you collect the interest payment while the value of the bond stays even or rises).
2. Another is through maturity extension.  Which is to say adding carry by going longer out on the yield curve (e.g. 30 year bond yields more than a 3 month T-Bill).

• Both strategies of adding carry have risk.  If the economy picks up and Treasury interest rates rise, then portfolios more geared toward maturity extension will lag.  If the economy falters and Treasury rates fall, then portfolios more geared toward credit spread narrowing will lag.  Further, there are times when both could move down together, like in May and June and to a lesser extent even now. 
• As Gross notes, there are times when it is advantageous to be positive total carry or negative total carry.  Further, there are times when certain type of carry is more in vogue than others (e.g. maturity extension when the economy looks shaky).  Thus, as opposed to be more passive in our bond portfolios we are being more active. 
• Our analysis indicates that skilled active bond traders can find the best places to get carry depending on the environment.  But in the event one manager can’t, we are building around a few different ones to smooth out the returns.  We are blending these managers based on how much leeway they have in constructing their portfolios, some will favor adding carry through credit spreads and some through maturity extension.  The ultimate goal will be a bond portfolio that can stay afloat as interest rise, but provide support to the total portfolio when riskier assets pull back.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.