Too Good to Be True?

If an investment sounds too good to be true, it usually is.  If you don’t understand how the investment or the market in which it exists, that only amplifies things.  Still, neither of those means it’s a bad investment, it only means the following:

1. You probably don’t understand the risk
2. It’s time do some research

I bring this up as we were just pitched by an investment firm which is waist deep in experience and credentials on an investment strategy with:

1. High yield
2. Low risk
3. Non-correlation to the assets in the portfolio
4. Non-correlation to other asset classes

What an investment!  Frankly, I came out of that meeting, and my only concern was the title of this commentary.  So I dug a bit deeper…

1. High Yield – Yes, the yield was nice, but has also come down as other investors took a liking to this asset class
2. Low Risk – Kind of, but it remains unclear if the models used to price these investments are accurate.  Further, the now lower yield enhances this risk (i.e. you aren’t compensated enough for the risk)
3. Non-correlation to other assets in the portfolio – In theory, yes; however, it’s possible these assets all move together if everyone tries to leave the same broad market.  Hard to gage the likelihood of such an event
4. Non-correlation to other asset classes – Yes, until it isn’t.  By this I mean there are instances when this asset class would move with equities, and only at the time when you would need them not to do so

I don’t want to divulge the asset class because we are still doing our due diligence.  I just wanted to give an example that there is always more than meets the eye, and it is critical to dig and dig deep when presented with a possible investment.

However, just because we uncovered some risks doesn’t mean it’s not a good opportunity.  It just means we need to be aware of all of the downsides, weigh those against the possible return, and if it passes our screening process, explain all of this to the client where is fits accordingly.

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. 

The Freak Out

Mitzi, my mom’s dog, doesn’t get on the couch except when there is a thunder.  One clap of thunder and Mitzi jumps right up for the comfort of my mom.  As soon as the thunder subsides, Mitzi goes right back to sleeping on the floor. Not unlike Mitzi the dog, the markets get spooked when the equivalent of thunder causes alarm.

Bespoke recently highlighted the similar reaction the equity markets have had to the Fed Minutes release:

Another sell-off happened on July 10^th as well:  after the minutes release the S&P 500 shot up and then sold off roughly 0.60%.  Where are we since the last Fed sell offs?

Despite the initial reaction, the S&P 500 is up since each of those Fed Minute release parties. 

Like most of the items in my commentary, I use this as an example – an extreme, short one at that.  It doesn’t tell you to invest or not to invest in stocks; however, it does show that markets can move quickly without fully digesting what is presented.

At times this can be a signal (times are changing) and at times it can be noise (a blip, but the trend doesn’t change).  The key is to try and distinguish between the two, but that can be difficult.  Thus, the most important takeaway is not let emotions dictate your investment decisions, which can lead to buying at the top and selling at the bottom. 

Having a plan in place and executing that plan is the best way to keep yourself in check, minimize risks, and subsequently gain long-term returns.   

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. 

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. 

Making Sense of Recent Market Moves

The last week or so has certainly caused some anxiety among equity and fixed income investors.  I decided Sunday and Monday to look more in depth and draw some conclusions.  

What follows is my analysis, which I sent out to our firm; however, does NOT include the corresponding research behind it or the awesome, pretty charts.  I should note that without the research in which to refer, the bullet points may be a bit hard to digest.  In those instances, if anyone wishes further details please email me (zabrams@capitaladvisorsltd.com).

As I write this, prices have seen some reversal, which in some ways encapsulates what I am trying to illustrate below.  The key, whether or not I am right or whether I am wrong, is to focus on the intermediate-term window, try and funnel out what is happening in these violent short-term moves, and don’t panic!!

• The markets of late have been interesting as stocks and bonds have both seen downward market volatility.  This makes asset allocation a nasty task
• Starting in 2009, rising yields have been bullish for stocks.  Falling yields have been bearish until they hit their floor.  However, the general low level of interest rates has been bullish for stocks (lower interest rates = lower discount rate = higher valuations AND lower interest rates = lower cost of borrowing = higher EPS).  Thus, it seems logical that the higher yields, higher stock prices makes sense for the time being as the move in interest rates has been large and could be construed as a secular change   
• When put in perspective neither stocks or equities looks as bad, but should continue to be watched.  Further, a 3% to 4% loss in bond portfolios is hardly reason for panic
• Bonds in particular appear due for at the very least a short-term bounce
• Stocks could have more to go, but should have a floor as:
• Lower prices increase likelihood of Fed loosing
• Economic data is too good for stocks to ignore
• It’s likely that either bond yields settle OR move down given at some point the rising yields will probably hurt the economy and loosen Fed policy
• Even If they don’t (e.g. the economy gains in strength) then properly allocated fixed income portfolios should be  hedged as:
• Stocks should perform well
• Active fixed income management should outperform passive
• Duration should be relatively low
• As it relates to portfolio management the above points to:
• Letting this FMOC re-calibration shakeout and remaining calm
• If there is a need to pull the trigger, a small move to cash is probably the best place to go instead of a secular change in the portfolio (e.g. selling a portion of intermediate-term bonds and moving to cash > selling all intermediate-term bonds and moving to short-term bonds)
• Even if this is the start of a secular move in interest rates, the odds are likely there will be a short-term reversal
• Use the market trends as a guide and not a road map to violent short-term moves
• At some point soon, diversification will work again in terms of moderating (though not completely containing) risk 
• I still think the highest probability path is this: rapid rise in interest rates hurts economy > equities struggle > yields lower in anticipation of Fed loosening (maybe not QE though) + safety > stocks fall until easing back on > yields range bound.
• Note: an alternative would be if interest rates continue to rise as growth improves, which again is bullish for equities.  Not so much for bonds

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. 

The Equity Paradox

The equity markets have scorned investors like young love gone badly.

As a result investors are scared to get back in the game.  And herein lies what I like to call the paradox of equities – in order to get the larger returns needed to make it comfortably to and through retirement, an investor needs to take on more risk, which thus increases the chances of catastrophic portfolio loss, which in turn severely inhibits gaining those larger returns.

A recent NYT article a friend sent me outlines this in more detail.  The gist of it is that the bulk of Americans are under saved, regardless of income level and net worth and thus need higher returns to meet their goals.  For example, if you have a $4m in savings, but are accustomed to spending $300K a year it may not last through retirement.  If we assume a 5% return, that money runs out in about 22 years.

There are a few things that complicate the above calculation and could cut that 22 years down even more – low bond returns, unfavorable longer-term equity valuation levels, timing of initial investment, and large drawdowns earlier in retirement, among other things. 

This is where a good advisor can help seek balance in this paradox by assisting a client in taking on the risk needed to get the returns and meet their retirement goal. This can be accomplished as follows:

• Cash flow modeling to see if/when client runs out of $ and adjust accordingly
• Moderate AND contain portfolio risk
• Make sure the client is understands and is comfortable with the risk/return profile of his/her portfolio
• Prevent the client from making the psychological mistakes (e.g. go all in at the top and sell out at the bottom)
• Increase the after-tax rate of return. As is said, it’s not what you make, it’s what you keep.
• Most Underrated:  an advisor can provide counsel to clients, who have questions about their portfolio, how it’s constructed, the market environment, etc.  Getting piece of mind and being able to sleep at night is imperative to prevent some of the biggest mistakes investors make. 

That list is by no means all encompassing; however, I do think it provides and adequate short summary of things advisors MUST do to get their client to and through retirement.  In most cases that involves taking on some sort of equity exposure, even if equities are no longer as popular as they once were. 

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.