Following the Lead on Interest Rates Isn’t a Strategy

Building a portfolio based solely on market consensus or projections isn't a strategy – it’s hope based investing.

Interest rates going up has been the consensus view since 2009.  Eventually this view will be right, so far it really hasn’t.  When exactly they go up I am unsure of, though I tend to think later than most. 

One thing I will not due is blindly follow market projections or consensus calls, which appear to be nothing more than throwing darts.  While the recent Fed statement contains “considerable time” before an interest rate increase, futures markets are assuming this will happen mid 2015:

Note:  This chart isn’t easy to read.  The blue line shows the actual Fed Funds rate, which is effectively 0 and has been since mid-2009.  The orange line shows what the futures market is predicting the rate will be in the future at the start of the line (e.g. when rates reached 0 in mid-2009 futures markets expected rates to rise back up quickly and be at 2.50% or so by mid-2010).  Lastly, the green line shows where we currently are that rates are projected to rise in mid-2015 and be at almost 3% by 2017.  Also, this chart was printed before the latest Fed Statement and thus futures markets may have adjusted.

What we can observe in the above charts is that market participants always expected the next rate rise to come and it never did.  Now markets did get better, projecting the rate rise out further and further, but none the less were still off. 

Will it be mid-2015?  Not sure, but even some widely used Fed models project the rate increase will be further out:

What about consensus analyst?  Not much better:

Source:  DoubleLine Funds

As you can see the black line where analysts expect the 10 year to be at year-end.  It has consistently moved down all year, along with interest rates.  Again, analysts have missed the calls on interest and this has been a reoccurring theme since 2009.

I am not advocating totally ignoring projections (though not a terrible idea I must admit and certainly better than the other extreme – following them religiously), nor am I advocating making your own market calls. 

But building a portfolio based solely on market consensus or projections isn’t a strategy – it’s hope based investing.  Instead, 1) make probabilistic assessments 2) have a plan if/when those move against you.

*Please see the important disclosures that apply to this commentary HERE.  The above charts are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

Bonds Holding Strong?

Bonds are moving against what logic would dictate this year and investor portfolios should be prepared for a multitude of outcomes.

As of last Friday bonds, as measured by ETF AGG, are up 2.88%. (per Yahoo! Finance)  This is a slap in the face to the consensus, which expected yields up and bond prices down.

Here are some facts/consensus:

1. Stocks are also up a little over 2%.  (per Yahoo! Finance)
2. While economic growth stunk it up in Q1, consensus is still positive for the year.
3. The Fed is tapering, which means they are buying less long dated bonds.

The above, at least in theory, should equate to higher bonds yields and lower prices because:

1. Stocks and bonds are thought to move in opposite directions as the former is considered risk-on and the latter is risk off.
2. Positive economic growth should increase risk appetite (see above) and inflation, which hurts bonds.
3. Less buying = less demand with same supply = lower prices = higher yields.

So it all makes sense for higher yields, but maybe this is the reality:

1. Stocks and bonds aren’t really negatively correlated.  Sometimes they move together, other times they don’t, sometimes they move in opposite directions.  It really depends on the period.
2. Maybe bonds are telling us the economy isn’t going to pick up?  Inflation is still in a downtrend too. 
3. Some other buyers are picking up the slack.  Think about it, a 10 year at 2.60% is a lot more appealing than at 1.40%.
4. BONUS!  The bond market is wrong.

I am not sure which one it is, but one thing is certain - bonds are moving against what logic would dictate this year and investor portfolios should be prepared for a multitude of outcomes.

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.

Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market.  Moderate inflation is a common result of economic growth.  Hyperinflation, with prices rising at 100% a year or more, causes people to lose confidence in the currency and put their assets in hard assets like real estate or gold, which usually retain their value in inflationary times

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Despite Falling Prices, Fixed Income Still Has a Place

Investors need to balance the expected fall of bond prices (portfolio ladder, tactical managers) with the benefits (equity hedge, price stability) that fixed income brings.

The 10-Year hit 3% at the end of 2013 while the Aggregate Bond ETF fell just under 2%:

Not to beat the thesis to death (see the bold paragraph here), but moving forward rates are expected to rise.  If we assume this to be the base case and bond prices fall, a logical question is why hold bonds at all? 

To answer that, let’s first examine the roll of a fixed income portfolio: 

• Despite being correlated over longer time periods, bonds can provide stability in the event equities fall.  From August 2007 to March 2009, using monthly closes, US stocks had an annualized return of -30% while US bonds had an annualized return of 6%.  Diversification away from equities with bonds minimized portfolio volatility.
• Utilizing the same data going back to 1970, we see the max drawdown on US stocks was 51% while for bonds in was 13%.  Thus, historical returns indicate the largest amount of risk in a portfolio is from stocks.
• See the above, that even with a 70% plus climb on the 10 year interest rate, AGG was only down 2%.  For returns of other Fixed Income ETFs, see here.
• A caveat to the previous bullet is making sure the portfolio’s duration risk (the sensitivity to interest rate changes, the higher the duration the greater susceptibility to rising interest rates) is managed.  If we look at TLT (iShares 20+ Year Treasury Bond) the duration is over 16 years and the ETF was down roughly 17% in 2013.  

To summarize, a fixed income portfolio with managed duration risk can provide a hedge against a falling equity market and is not at a high risk for large principal loss.  Still, we are left balancing the prospect of rising interest rates with the diversification benefits that fixed income bring:

• Laddering individual bonds or ETFs with a set maturity assures that an investor face value of the bond back (assuming no default) and can lessen the sensitivity to interest rate changes as bonds that come due will be re-invested at higher rates.
• Utilizing tactical managers who can enhance returns even if interest rates are rising.
• Find attractive relatively attractive yields in fixed income (e.g. municipal bonds).

While these ideas attempt to weigh rising rates with diversification, ultimately there is no free lunch – any move to hedge against rising rates probably reduces one’s ability hedge against a falling equity market.  It’s imperative each investor recognizes this and then decides on his or her own course of action.

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.

2013 and Beyond – The Bad, and The Ugly

Negative ETF Ranking - 2013
9	-1.37% - shares International Treasury Bond ETF (IGOV)
10	-1.83% - iShares S&P GSCI Commodity-Indexed Trust (GSG)
11	-1.98% - iShares Core Total Aggregate U.S. Bond ETF (AGG)
12	-2.00% - iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
13	-3.44% - iShares National AMT-Free Muni Bond ETF (MUB)
14	-3.64% - iShares MSCI Emerging Markets ETF (EEM)
15	-6.09% - iShares 7-10 Year Treasury Bond ETF (IEF)
16	-6.73% - iShares Emerging Markets Local Currency Bond ETF (LEMB)
17	-28.33% - SPDR Gold Shares Trust (GLD)

Shockingly, not every asset class went up last year.  I say shocking because usually when stocks are hot nobody really cares what anything else is doing.

Last post I covered the ETFs that finished in the black last year and what we should expect moving forward.  This time I will cover the ETFs that finished in the red in 2013 (with the help of this file).  Again, when looking forward I am using this thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk.  Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat.  On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap.  The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

I will again mention the caveat that what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned and when things change portfolio and thesis adjustments will be made accordingly…

And now, the ETFs that had negative returns in 2013…

• IGOV – 2013:  International treasuries almost finished positive, but alas they finished with every other fixed income asset class.  They did finish the second half of the year very strong with the help of a weaker dollar.  Moving Forward:  While the US is pulling in the reins on QE – pushing our yields higher and bond prices lower – other countries are expected to remain easy or possibly become more accommodative (see Japan’s “success” with their own QE).  This would push their yields lower (or stable) and prices higher, but also cause their currencies to fall and thus washing out any positive.  Thus, an investment that is USD hedged could provide some boost.
• GSG – 2013:  The commodity chart looked a lot like USO last year, but worse as it includes agriculture and precious metals.  Commodities look to be in a range, and while that’s subjective the alternating black (Q1, Q3) then red quarters (Q2, Q4) would appear to validate that.    Moving Forward:  see USO (note: energy and industrial metals make up the bulk of index).
• AGG – 2013:   The pulse of the US bond market had its first negative calendar year return since inception and didn’t break its intermediate-term trend for the last eight months of the year.  Interestingly though it only had one negative quarter (Q2).  Moving Forward:  Assuming interest rates to continue to rise in 2014 it should yield another negative year for bonds.  While it appears interest rates may have hit a secular bottom in 2012, it’s important to remember that bonds hedge against a decline in risky assets (note: this has held as of late with equity markets off their highs and AGG moving up) and that they present much less risk (unless they are high yield or high duration) in terms of large capital loss.  Finding a balance between rising rates and the portfolio hedging benefits fixed income brings should be the goal.
• LQD – 2013:  See AGG, though the Investment Grade Corporate Bond LQD did break its intermediate-term downtrend at the end of the year.  Moving Forward:  See AGG.  There doesn’t appear to be much room for investment grade spreads to compress any further, so outside a 2008 credit event I would think they will have a high correlation with Treasuries.
• MUB – 2013:  Munis were hit harder than their taxable counter parts in 2013 with Detroit’s bankruptcy taking center stage.  While they did recover in the later part of the year, MUB like AGG finished the year below its intermediate-term trend for the last eight months.  Moving Forward:  Quick math, 3% yield on MUB equates to a tax effective yield at the 40% bracket of 5.00%.  AGG has a yield of 2.32%.  So if you are in a higher tax bracket, pick out some attractive munis, ladder them by maturity, hold to maturity, and you get a decent yield with not much interest risk. Note: as interest rates rise prices do fall, so prepare to watch your values drop, but if you hold to maturity you get the face value back.
• EEM – 2013: While EEM finished with two positive quarters and the last three months above the intermediate-term trend (barely), it still couldn’t overcome a poor start to the year as money moved out of Emerging Markets when our interest rates moved up.  EEM is also over 60% below its 2008 peak.  Moving Forward:  Even more so than developed markets, emerging markets appear to have an attractive relative valuation to our market.  Much of this is likely due to some longer-term demographic and geo-political issues and is especially true of the ones that got beat up last year (Russia, China).  Further, a sharp rise in US interest rates could continue the capital flow out of emerging markets.  Thus, while there are opportunities for upside until the trend reverses it’s hard to have much conviction.
• IEF – 2013: See AGG.  Moving Forward:  See AGG, though I think it makes sense to take a more tactical (over and under weighting when the market dictates) approach to the 7 – 10 year Treasury space.
• LEMB – 2013:  See EEM; rising domestics rates equates to capital moving from emerging markets local currency bonds back into US markets.  Moving Forward:  See EEM and IGOV.  While rising domestic rates would continue to be negative for emerging market bonds, a USD hedged exposure could be a nice boost.
• GLD – 2013: The gold chart for the year went pretty much straight down.  You can take your pick why: higher interest rates, decrease in systemic risk probability, lower inflation.  But at the end of the day you see three out four negative quarters, the whole year below the intermediate term trend, and down nearly 30%.  Moving Forward:  All three items I listed for gold’s 2013 decline are still in place.  Maybe one of those reverses and this turns into a great contrarian trade, but until the trend changes it’s difficult to allocate dollars to gold.

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.

2013 and Beyond – The Good

2013 is a wrap!  What a year it was if you invested solely in US stocks.  Just a guess, but I would wager some investors probably will think now is a good time to get undiversified.  That could work in 2014, maybe even longer, but ultimately other asset classes will begin to outperform and a diversified portfolio will provide good relative returns with lower volatility. 

But that discussion is for another day.  Below are some observations on ETFs (listed at the top) we look at that yielded positive returns last year.  I used this file to help make those observations.  For each ETF, I summarized 2013, and then outlined what should happen moving forward, based on the following thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk.  Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat.  On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap.  The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

Will all that happen?  Probably not, but these are my conclusions based on the current environment.  Of course as the markets and facts change so will the above thesis; in other words, as I have pointed out before, nothing is static.

Making predictions is a futile business, so what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned, with the caveat that when things change portfolio and thesis adjustments will be made accordingly… 

• IWM – 2013:  US Small Cap stocks were best in show and never came close to breaking their intermediate-term uptrend (roughly 10% above the 10-month moving average).  Small Caps leading Large Caps is a good sign to market observers, though they also lagged a bit (still up over 8%) in Q4 and is something to keep an eye on.  Moving Forward:  This equity market segment seems relatively pricey to others and above average.  While the environment is conducive toward continued appreciation, I prefer higher quality companies with strong balance sheets that tend to land in the large cap space (SPY) in case some of those conditions reverse or something unforeseen happens.  Still, the trend in US stocks (this includes SPY) is overwhelmingly positive and as a result our risk metrics have not been triggered, in fact IWM and SPY are far from them.  So until the environment changes or the risk metrics tell us otherwise it’s difficult to go against the market.
• IVW – 2013:  Growth had little difference from the Value stocks ETF, thus if you were invested in stocks it really didn’t matter much.  Moving Forward:  see SPY/IWM.
• SPY – 2013:  The S&P 500 ETF that everyone looks at really ripped and was up over 30% on a total return basis.   Q4 was also the strongest quarter of the year and the index hit its high in the last week of the year.  Like IWM, SPY never came close to breaking its intermediate-term uptrend.   Moving Forward:  See IWM, though valuations are more reasonable than small caps and probably at their average.  I will again note, I prefer the quality companies moving forward that capture part of the up move, but also avoid some of the down move in the event the market reverses course.  Lastly, a major fundamental equity concern is what happens as interest rates rise; however, in this environment rising interest rates have historically been a benefit to stocks.
• IVE – 2013:  see IVW.  Moving Forward:  see SPY/IWM.
• EFA – 2013:  Investing in developed international market stocks netted 20%+ though still had a decent lag relative to domestic stocks.  The ETF is also still below its 2007 peak, but it’s close to making a new high on a total return basis.  Moving Forward:  Looking at prior returns and research, these markets tend to be a better relative value than our own stock market.  What this doesn’t mean is that outperformance will happen overnight.  Further, the trend is NOT your friend.   What it does mean is that there are some opportunities here, especially as growth in those economies picks up. 
• USO – 2013:  This is the first significant relative underperformance as the oil ETF’s return was a tad under 6%.  Moving Forward:  Typically cyclical commodities tend to rally more late equity cycle (see big Oil rise in 2007 and 2008 before it cratered), so assuming the equity market rally still has legs, I would expect the lag to continue.  Further, many investment based countries (e.g. China) are trying to shift to a more balanced economy.
• HYG – 2013:  Only bond asset class up for the year, which isn’t surprising given high yield is more correlated with equities and has minimal duration risk.  Moving Forward:  Environment should still be supportive.  However, while spreads (the difference between Treasuries and a similar high yield bond) have been narrower before, I do wonder how much juice is left in the squeeze?  Just be careful as high yield bonds won’t provide a hedge if riskier assets stumble.
• IYR – 2013:  Logic would dictate real estate would perform better given a big bullish economic story last year was the increase in home prices, but IYR barely finished the year in the black.  The chart looks eerily similar to the Treasury ETF, so there appears to be a correlation with interest rates.  Plus REITs outperformed stocks every calendar year since 2009 except last year, so maybe much of those gains were priced in.  Moving Forward:  The correlation between real estate and stocks broke down for much of 2013, but did move together prior to that.  Still, steadily rising interest rates with minimal inflation should result in lackluster performance and a loose correlation with bonds. 

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.

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.

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.

Winds of High Yield Change

Since early May Treasury interest rates have shot up over 30% (still when put in perspective, not that all that much).  Bond prices and interest rates have an inverse relationship, so when interest rates rise bond prices fall. 

It’s easy to think about this relationship in a practical sense, if Bond A is yielding 5% at time 0 and a similar Bond B is yielding 6% at time 1 then why would anyone own Bond A at the same price they could buy the higher yielding Bond B?  Thus, the price of Bond A falls.

So given the above it logically follows that recent spike in interest rates would have led to a fall in bond prices.  That indeed happened: 

What’s interesting about the above is that high yield bonds and preferreds, HYG and PFF, also moved down in value.  This didn’t happen in late 2012 through March of this year when Treasury yields also had a 30% rise. 

This could be the start of another shift in the market.  In this instance, high yield bonds and the like may move more with the change in Treasury interest rates, where in the recent past they moved with equities:

There are a few takeaways here:   

• The spread (difference in yield from high yield bond over a Treasury) may be done contracting for the time being.
• Note:  Since I wrote this spreads have moved up, which makes high yield bonds more attractively valued
• If it consolidates into the current range, the spread return (e.g. yields on high yield bonds fall when Treasury yields stay constant or even rise) will no longer be existent.
• Thus, the return from high yield bonds will be a combination of the interest paid on the bonds and change in Treasury interest rates (ipso facto, Treasury yields rise, high yield bonds fall and vice versa).
• The caveat would be that if equity markets fall apart, high yield bonds will probably follow.
• Therefore, if high yield bonds are yielding 6.50% + another 2.50% if Treasuries revert back to 1.60% or so level (a rise from this level resulted in a 2.50% fall in Treasuries) and assuming the spread stays constant means the upside is roughly 9.00%.
• On the flip side, the risk is larger than 9.00% given the correlation to the equity markets, if they fall. 
• Further, if Treasury interest rates rise steadily this will also hamper returns, though I don’t think there is substantial downside to high yield bonds in this respect. 

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.  Nothing in the above writing should be taken as an investment recommendation.