Bonds Aren’t as Stupid as Their Yields Indicate

Buying and holding bonds in the current environment might make you ill.  If you hold a Treasury Bond for 10 years you receive roughly 2% on that money annually for the next 10 years.   That’s in nominal terms too.  If inflation averages a little more than 2% that you essentially get 0%.  Higher quality corporate bonds aren’t much better.

Note: Left graph is based on 10-year Treasury bond coupled with inflation expectations.  Right graph is AA Corporate effective yields.

To summarize the graphs – buying and holding a Treasury or high quality corporate bond for 10 years is the investing version of Chinese water torture.   So why invest in bonds at all?

• They still will likely provide the best hedge against a declining equity market.  From November 07 to March 09 S&P 500 declined 44% with the Aggregate Bond Index was up 7%.
• Smart money is on Fed staying loose and keeping interest rates low for some time.  Even if they taper bond purchases later this year or early next year.
• Demographics and risk aversion provide a market for higher quality bonds. 
• Yields can stay low for a long time.  Ask Japan.
• Since 1976 the Aggregate Bond Index max loss over a 12 month period has been 9%.  Not what I would call a catastrophic loss so your principal probably won’t be decimated. 
• The world bond market is $90 trillion (compared to equity market size of $40 trillion), so there are a lot of places to seek out return (i.e. there are more than just Treasuries and Corporates out there).
• There isn’t a bubble, at least anecdotally.  How many investors you know brag about their bond portfolio over the past few years and compare that to their real estate portfolio in 2007 or their tech stock portfolio in 1999.
• Check this out:

That shows the 10 Year bond going from 2% to about 1.60% in a little less than 2 months.  It also shows the long bond ETF going up in value.  Point being, bond trades can capitalize on these quick moves in yield.

I take all of the above and come up with the following bond investment cocktail.

1. While the risk of buying and holding is probably low, the upside is muted when it comes to quality bonds.
2. Still given the depth of the bond market and short-term moves in yields, returns can be had.
3. Thus, move away from more passive buy and hold bond investing to quality managers who have the leeway and skill to navigate the fixed income space.

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. 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.  

Correlate That – Diversification Requires a Deeper Look

You may think your portfolio is diversified and you may be right or you may be wrong.  In defense of your diversification strategy, you may point to how various asset classes have interacted over time.  That’s really nice and it might make you feel good, but you may need to look deeper.

Below is a chart on 3-Year Rolling Correlation to US Stocks using monthly Morningstar Direct data.  If you are confused on what “Rolling” is, here is a quick summary:

When something is said to be rolling it's tracking a certain amount of time in the past, and then rolls forward as time progresses. So the 3 year rolling correlation would be the correlation between stocks and another asset for the past 3 years. Next month, we add one more month (current month) and subtract the last month from the prior calculation.

Basically this is any easy way to smooth out the data so you can see how various asset classes have moved over an intermediate time-period. 

One thing that sticks out to me is the increased correlation over time of equities – Developed Market Stocks, Emerging Market Stocks, and REITs.  Thus, having a diversified equity portfolio holding these asset classes would do little to combat a fall in Domestic Equities.   Commodities of late have also not proven to be the diversifier they once were, though currently this is starting to breakdown.

The takeaway is to be diversified for the current market environment. Diversification still entails the strategic longer view of markets, but it also requires a tactical shorter-term analysis in order to be diversified and minimize portfolio volatility.  If you are diversified given the correlations of the past, you could be in for a rude awakening.  

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. 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.  

Japan – Ugly Duck Turned Swan

Anecdotally, Japanese equities have been the whipping boy for a long period of time (and also ugly since 1990):

That is an ugly chart.  But times are a changing: 

If you’re wondering why here is a quick, universally accepted, summary:

Mr. Kuroda (Bank of Japan’s new governor) promised to double Japan’s monetary base as well as its holdings of Japanese government bonds. The maturity of the bonds it purchases will increase from an average of about three to seven years. To make its intentions clear, the bank merged its quantitative-easing programme into its regular operations. This time there was no need to read any tea leaves: the BoJ simply said it "will achieve" inflation of 2% in about two years’ time.

In short, the Japanese are trying to create inflation by purchasing bonds.  Similar to what the Fed is doing here - quantitative easing where cash at central banks is used to purchase bonds.  The difference is in Japan this is on a relatively more massive scale. 

This in turn has depreciated the Yen versus the dollar, which is why while the ^N225 is up 70% buying an ETF (EWJ) and converting back to dollars would only have you up 35%.  But given the dearth of ETF products you can purchase an ETF that hedges out the Yen’s decline (DXJ) and be up a little over 60%. 

In the past when Japan has tried something similar to this on a much smaller scale, the equity market rallied over 100%.  Still the equity market also has a 20 year history or large moves up followed by large moves down.  So while there appears to be some more room left to run in the equity market (and for USD vs. Yen) given the size relative to past QE experiences, there is a certainly a question of sustainability considering the history of the equity market and what appears to be smoke and mirrors by the BOJ. 

Past performance is no guarantee of future results.  International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. 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.  

Low 10-Year Return Projections <> Underweight Equities

The stock market looks expensive when you take an intermediate term view (3 to 10 years).  That sounds a tad frightening, but don’t let the long view lead to short-sighted decisions in your equity portfolio - at least for the next 12 to 36 months.

A recent MarketWatch article, by Mark Hulbert points to indications of long-term overvaluation and asserts the following:

1. Stock market is not at all-time high in real terms and is 24% below the peak.
2. CAPE (i.e. long-term Price to Earnings, a longer-term valuation metric) suggests weak market returns over the next 10 years (close to zero in real terms).
3. Despite CAPE being rich, it doesn’t mean markets will move in a straight line down and the recent rally (I assume since the 2009 bottom) can continue.

I believe we run similar in-house models to Mr. Hulbert, and while I tend to agree, they do need some context:

1. This suggests the market still has more room to run.
2. Other valuation models we run indicate a similar trend.  But over time market valuations have trended up, suggesting the decline may not be as severe as the average would dictate.
3. The market can stay overvalued for quite some time and the conditions appear to be in place them to do so.  I actually just heard famed investor Joel Greenblatt mention the market is cheap on his free cash flow measure, a shorter-term metric, and this is confirmed amongst sell side research we use.  Also, momentum metrics can help determine when a change in the market is afoot.

So I am on board with the contention the market will revert to the mean as this market cycle ends, leading to a correction, which very well could be larger than anticipated by most.  But I also think there needs to be some perspective around it – don’t miss the upside while you wait for the mean reversion.

The takeaway is to make sure you and your advisor are aware of the longer-term trends and the likelihood of mean reversion, but don’t avoid stocks altogether.  Just have a plan to mitigate the risk when the upside trend starts to reverse. 

Past performance is no guarantee of future results.  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.  

Looking for Trades?

My thought on trading, a short(er)-term speculation with some sort of catalyst and strategic entry and exit points, is to always do your own research and then look for outside opinions to validate or strike down your trade thesis (typically strike down to avoid confirmation bias).  While short-term speculative trading is not our bailiwick, several of our clients have personal accounts where they like to do so and we will opine where we can.

What brought this to mind was that the Ira Sohn Conference took place last week. It brings together some great investors to discuss their various ideas in a shot-gun format. What better way to validate or strike down your trade thesis than to compare it to what some of the best traders are doing? 

I don’t know how you get into this party, I am guessing it’s highly exclusive and/or expensive.  Luckily, my research turns up several commentaries: 

• WSJ
• Zero Hedge
• Josh Brown
• Many more here.

The topics covered were broad: macro trends, stocks, economic policies, subsequent central bank bashing, and more.  I need to say I am not suggesting anyone go out and trade any of the ideas from this conference because person XYZ said it was a good idea and past results have been mixed.  As I said earlier, do your own research.  Still the links can provide a good starting point to begin engaging in said research or to vet currently existing research.

In the end I think it’s important when trading -- and I always try to mention this to clients --  to ask yourself, “if I am buying why is someone else selling or vice versa?”.  Research and perspective are the keys making a trading decision.

Past performance is no guarantee of future results. An investment concentrated in sectors and industries may involve greater risk and volatility than a more diversified investment.  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

Utilities, Still on Defense?

The JP Morgan Guide to the Markets is out for Q2 and is always a good place to find some fun charts and a recap of the prior quarter.  I usually peruse through it when it arrives in my inbox.  This quarter, something in particular caught my eye – in Q12013 Utilities are up more than the S&P 500 (SPX). 

The sector was up 13% and the index was up 10.6%.  This is odd as Utilities are typically defensive so when SPX rallies hard like it did in Q1 you would expect Utilities to lag.  Over the last 10 years the beta (how Utilities move relative to a move in SPX) is .52, which means since SPX was up 10.6% Utilities should have been up roughly 5.50% based on the last 10 years of historical moves.  So why did this happen?  I have two thoughts:

• Search for yield.  The 10-Year Treasury floats around 1.75% with SPX around 2.00%.  Utilities yield about 4.00%.  This feeds into…
• Capital Protection.  Investors are still nervous from 2008 and 2009.  Given the low yields, investors feel more compelled to reach for yield and return in less volatile equities.  This is evidenced by large moves in other low beta, defensive sectors – Health Care, Staples, Telecom – in Q12013.

This presents two questions.  The first is will these conditions persist?  I think yes given QE (Fed won’t let rates rise) and investor psychology being extremely sticky.

The second is what happens if the market reverses?  Utilities are roughly 30% overvalued to their historical norms.  Thus, the risk is that if the market starts trending negatively, the downside protection Utilities provided in the past may not hold this time around.  Though if the market moves higher and Utilities lag this could correct itself before an overall market correction. 

Thus, the conclusion I draw is that while the conditions driving Utilities higher are still in place, I am concerned their upside potential does not compensate for the downside risk.  This kind of market disconnect can have great bearing if there is a sudden increase in downside market volatility as the investor could be subject to more risk than initially thought.

If decent yield with a defensive posture is a prime goal, an investor may be better served looking at alternatives to this sector or, at the very least, understand the risk.

Past performance is no guarantee of future results. An investment concentrated in sectors and industries may involve greater risk and volatility than a more diversified investment.  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.  

Draft Weekend

The NFL Draft was last weekend.  We now have the absurd post-draft grades, where despite these players never having played a down, teams are given an evaluation based on perceived value of the picks.

While not as absurd, I do find it silly that NFL GMs are considered great or horrible based on a handful of picks.  Think about it, if roughly 60% of picks pan out a GM is considered “good”.  That’s a bit better than a coin flip.

For simplicity, let’s assume the first two rounds present the only chance of producing legit starters, and assume a GM has about three years to show results.  Thus, in three years a GM must count on roughly 3.6 picks in the first two rounds to become good, if not great, starters.  If only two succeed he is a total failure, three he’s average, and four plus he is probably a success/genius. 

The sample size is extraordinary small, the success or failure probability is essentially even, and the margin of error is narrow; so the results of the pick are not a good indication of a GM’s skill or luck, at least over the course of a few years.  Thus, it’s the process that matters – how do GMs evaluate players?  The success of a player is probabilistic and therefore there is always a chance of failure.  A GM can do everything right in terms of his process, yet ultimately have a poor result. 

No, I haven’t started a sports blog, but I do see many parallels between a portfolio manager (PM) and a GM.  A PM can have years of underperformance, but have a strong process and will ultimately show skill and subsequent outperformance over the long-term (i.e. the skill of coming to solid probabilistic conclusion is born over a large sample size).  Therefore, it is how they invest, not the short-term returns, which are of concern to me.  Investors typically make the mistake of selling a manager early or passing on one altogether because of terrible one or three year returns, when qualitatively the same process is in place the has led to exceptional long-run performance.

For NFL GMs, unfortunately they aren’t graded on the same curve as I grade PMs.

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.