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.