Friday, February 17, 2017

Bond Dilemma



I am often questioned by clients about the makeup of the "fixed income" or "bond" portion of their portfolio.  Most clients understand risk associated with stocks--but the risks associated with interest bearing investments is less well understood.

Portfolio Allocation often is oversimplified as "60/40" or "70/30" referring to the mix of stocks and "bonds".  (i.e. 60% stocks and 40% interest bearing fixed income.)  In reality, Portfolio Allocation is much more comprehensive in that it relates to the form and benefits of "diversification".

The purpose of the "interest bearing fixed income" portion of the portfolio is generally two-fold. First to provide investments that are more stable and therefore less risky. Second, to provide investments that often are negatively correlated to stocks. (Negative correlation is when stocks "zig" then bonds can "zag.) So, essentially the purpose of the "interest bearing fixed income" portion of the portfolio is to reduce the volatility and risk of the portfolio.

What is often misunderstood, is that many fixed income investments carry SIGNIFICANT risk of loss.  When interest rates rise, the market value of the "bond" can fall significantly.  The longer the "term" or "maturity" of the bond, the more it will fall.  So, when interest rates are historically low, an important part of risk management is to hold more stable fixed income investments----meaning short term.

The definition of "short term" is important. To some, a one year maturity is "short". To another, "short" is more like 90 days.  The markets often tend to now use the term "ultra-short" or "cash" for investments that mature in 90 days or less.













The graph shows the "dilemma".  (Click on graph to see it bigger.) In the last six months, as interest rates increased only slightly: Ultra Short Term Fixed Income was essentially unchanged at 0.12%; 1-3 year US Treasuries fell by 0.72%; Short Term Corporate Debt fell by 1.39%; and 10 year US Treasuries fell by 6.23%.

Imagine having $400,000.00 or 40% of your "60/40" so called "conservative" portfolio invested in 10 year US Treasury Bonds (thru mutual funds or ETF's) and suffering a $25,000.00 loss in portfolio value!

So, since 2014, with the FED and other Central Banks engaging in unprecedented interest rate reduction strategies, the risk of rising interest rates has created this dilemma: Make low interest but take low risk, or try for higher interest and take the risk of suffering substantial loss. Such is the "dilemma" always faced when evaluating the best investments for a truly diversified portfolio that carries the level of "appropriate and acceptable" risk.

Thursday, December 8, 2016

Post, Post Election (The Really Big Event happened in July)



Will the election of "dark horse" Donald Trump be the biggest event of 2016? Well, certainly it is a "big event" but many, including myself think that the end of falling interest rates (rising bond prices) will be the "biggest" event with the largest financial impact. 

Today, Myles Udland wrote an great article..

2016-marked-the-end-of-the-biggest-bull-market-of-our-lifetimes



"In 2016, the nearly 40-year bond bull market ended. Date of death: July 11.
And this was the biggest economic event of the year.
“The biggest of 2016, in a weird way, was not Trump, was not Brexit, was not the end of the OPEC war back in February, it was July 11,” Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, said at a panel on Wednesday.
“On July 11, 2016, a couple weeks after Brexit, the 30-year Treasury yield fell to 2.088%. On that day, the Swiss government could borrow money for 50 years — out to 2076, a year most of us won’t be around to see — at a negative interest rate.
“And that day was the day that the greatest bull market ever, in the bond market, ended. Since then, yields have been rising. And that without a doubt is the biggest event of 2016."
For many investment professionals, a secular decline in interest rates is the only reality they’ve ever known. Since the Paul Volcker-led Federal Reserve cranked interest rates up sharply in the early 1980s to end US inflation once and for all, bond yields have been on a steady decline. Bond prices rise when yields fall.
Through the decades, however, there have been episodes of yields rising. And this is not the first time strategists have called for the end of the bond bull market. But since the early 1980s — nearly 40 years ago — interest rates in the US, and most major developed markets, have been in decline.
A move towards interest rates rising, not falling, has implications not just for financial markets but the real economy, too. Rising interest rates will pressure mortgages. Rising interest rates also make it more expensive for governments, and businesses, to borrow money."
This sentiment is being heralded by many "gurus" such as Bond Czar, Bill Gross and his former Pimco associate, now Financial Pundit, Mohamed El-Erian.


Ray Dalio is CEO of Hedge Fund, Bridgewater--largest in the world with $150 billion in invested assets. He is very smart and his commentary tells you a lot about how "big money" thinks about investing. He clearly indicates that "things are about to change".

Ray Dalio Commentary

"To clarify the distinction, one could have capable people driving conservative/right policies or one can have incapable people driving them, and the same is true for liberal/left policies. To understand where we are likely to be headed, we need to assess both. To be clear, we are more non-ideological and practical/mechanical because to us economies and markets work like machines and our job is simply to understand how the levers will be moved and what outcome the moving of them is likely to produce."

"Donald Trump is moving forcefully to policies that put the stimulation of traditional domestic manufacturing above all else, that are far more pro-business, that are much more protectionist, etc.  We won’t go down the litany of particulars about the directions, as they’re well known, discussed in my last Observations, and well conveyed in the recent big market moves. As a result, whereas the previous period was characterized by 1) increasing globalization, free trade, and global connectedness, 2) relatively innocuous fiscal policies, and 3) sluggish domestic growth, low inflation, and falling bond yields, the new period is more likely to be characterized by 1) decreasing globalization, free trade, and global connectedness, 2) aggressively stimulative fiscal policies, and 3) increased US growth, higher inflation, and rising bond yields. Of course, there will be other big shifts as well, such as pertaining to business profitability, environmental protection, foreign policies/alliances, etc. Once again, we won’t go into the whole litany of them, as they’re well known. However, the main point we’re trying to convey is that there is a good chance that we are at one of those major reversals that last a decade (like the 1970-71 shift from the 1960s period of non-inflationary growth to the 1970s decade of stagflation, or the 1980s shift to disinflationary strong growth)"

"As for the effects of this particular ideological/environmental shift, we think that there's a significant likelihood that we have made the 30-year top in bond prices. We probably have made both the secular low in inflation and the secular low in bond yields relative to inflation. When reversals of major moves (like a 30-year bull market) happen, there are many market participants who have skewed their positions (often not knowingly) to be stung and shaken out of them by the move, making the move self-reinforcing until they are shaken out."

Is this the time to buy???  Probably not. Opportunity is coming, but it will probably appear after we get the "big reset" in prices that will occur when the reality of increasing interest rates "sinks in" and becomes more certain.

Thursday, November 10, 2016

Post Election



As I have often mentioned...the "stock market" is made up of "investors" and "speculating gamblers". Mr. Market fell into a severe depression as election returns came in, but somehow snapped out of it, emerging in a euphoric manic state as soon as he heard Trump's victory speech.

Before and after the election, the "speculating gamblers" were busy.  There were many smug commentators who predicted market directions who have turned out to be very wrong--as they usually are! At least in the first days, the market has gone almost exactly in the opposite direction they predicted.

There are lots of "bets" being made.  Just since Friday, 11/4:

CAT is up 15.9%. Crane maker MTW is up 44.5%.  Aerial platform and construction equipment maker OSK is up 15.4%.  

Vulcan Materials is up 18.3%. But the giant concrete supplier, CX is down 6.1%--probably because it is based in Mexico, even though it's operations in the USA are larger than in Mexico.

(Most of the rise in prices occurred before or at the open, the morning after the election!  A sure sign of computer algorithm driven gambling.)

XOM is up 5.2%. Coal miner, ARLP is up 8.8%. Coal hauling railroad, CSX is up 10.4%.

Healthcare bellweather JNJ is up 3.3%.

But, 20 year US Treasuries have fallen 5.4%. And utility ED is down 5.9%.

So the bets are all about a rise in construction, as well as a reduction in hate for fossil fuels, especially coal.  Any maybe drug companies will be able to keep raising prices.

These assumptions seem reasonable, but perhaps a bit overdone.

What I think is the most important "trend" is the expectation of higher interest rates and inflation that are underlying the fall in US Treasuries and Utility Stocks. The two most important determinants of stock prices are earnings and interest rates. And, interest rates are essentially driven by inflation expectations.

Contrary to fears of a market correction caused by uncertainty regarding Trump, the markets have priced in a "hope" of a rising economy that will result in higher corporate earnings, with added effects in part from expected cuts in corporate tax rates. This MAY be a reasonable assumption, BUT...

The "elephant in the room" is the fact that many stock prices are presently assuming a "lower for longer" scenario and the expectations about growth and tax cuts seem to indicate a high risk that this "lower for longer" scenario is wrong. IF markets abandon this "lower for longer" assumption regarding interest rates...then price to earnings ratios must decline...the market will need to be "repriced" lower even in the face of rising earnings.

The risk of the market being "repriced" continues to be high--not certain--but probable.  So, investors should be cautious, and "ready" to take advantage of lower prices later. 

Enjoy the euphoria of a market with upward momentum, but be skeptical.  The real future is still quite uncertain. 



This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.





Monday, July 25, 2016

The Summer of 2016-Human Nature May be Wrong



In 2008, I wrote:

"Human nature is almost always wrong when it comes to investing. Many times, the most value a Financial Advisor can provide to a client is to help them GO AGAINST their human nature.

Our nature tells us to avoid injury by taking action in response to pain. In investing that means we want to sell that investment that has caused us pain and worry by going down in value. Investing is all about selling after prices go up and buying after prices go down."


Today, I would add, Investing is also sometimes about doing nothing. 

There are times to buy, times to sell and times to hold.

Lets take a look at two stock market indexes over just a little more than the last few months: The Dow Jones 30, a domestic only large cap index, and the DJ Global Ex US, an international only index.

In May, 2015, the DOW30 was at 18272.  Eight short months later, it had fallen 12.5% to 15973 in February, 2016. Six months later, now it is around 18470, up 15.6% since February but up only 1.2% since May, 2015. Like US bonds that are paying historically low interest rates, the domestic stock market over the last year has had a pretty anemic performance. 

In May, 2015, the DJ Global Ex US was at 246. It fell 25% by February, 2016. It has since risen 14.2% to about 211, but is lower by 14% from May, 2015. Like many international bonds with negative interest rates, the international stock market over the last year has had negative returns.

Despite, on average, poor corporate earnings growth, there is a "sentiment" by many that stocks are a "buy" because "there is no better alternative". Hence, the dramatic rise in both domestic and international stocks since February.

Stocks, by any measure, with the exception of the Energy Sector are historically overvalued. Some sectors, more than others.

On the other hand, there are many that see this recent rise and headlines of markets reaching "all time highs" as a sign to "sell" and take profits.

So, let me say again: "Human nature is almost always wrong when it comes to investing. Many times, the most value a Financial Advisor can provide to a client is to help them GO AGAINST their human nature."

The time to buy is when you have a reasonably strong and rational conviction that you are BOTH getting a good price and buying something with good prospects for growth. The time to sell is when you have a reasonably strong and rational conviction that you are getting a good price and selling something that has no good prospects for the future. (Getting a good price by the way has nothing to do with how much profit you have made--more on that later.)

The time to hold is when it not certain that you can buy or sell at a "good" price and you are not certain about the future prospects for growth. 

That "good price" for buying or selling has nothing to do with the past---it has only to do with the future.  A stock that has gone up in price in the past may or may not be an attractive stock to buy. What makes it attractive is whether it will produce dividend income and capital gains in the future. A stock to sell has nothing to do with it being a "dog" having declined in price in the past. And, a time to sell has little to do with a stock recently hitting a "all time high". What makes it a candidate for selling is that it's future prospects look bleak. 

I repeat: "Stocks, by any measure, with the exception of the Energy Sector are historically overvalued. Some sectors, more than others."  But, despite being historically overvalued, with a possibility of a price decline in the short run, I do not see a future bleak enough to justify any significant selling..nor with the exception of the Energy Sector, do I presently see any stocks that have BOTH a good price and good future prospects. 

Since we are in a period of high uncertainty, HOLD seems to be the wisest course of action, at least for now. Things change rapidly.  A significant pullback could create some interesting buying opportunities for long term investors. 

I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any such indication.This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.











Friday, June 24, 2016

Brexit Update--It is NOT 2008!



This is not 2008.

After the remarkable “recovery” of markets since the lows in February (Dow hit a low of 15,660) I warned that a Dow of 18,000 in April and early June was perhaps an overshoot to the upside and markets were a bit overpriced.  

Add to this an unwarranted smugness about the expected outcome being “Remain” on the part of the Press and many Wall Street Traders, one should certainly have expected a substantial downturn with the “surprise” result of “Leave”.

Often markets get caught up in an improper reliance on “myths” that are assumptions that are not based on fact. There is no doubt that Free/Fair Global Trade is a benefit to the entire world.  However, unfair Global Trade is harmful to some and beneficial to others.
Free/Fair Global Trade is not the same as Globalization. The myth that people will be better off if all “borders” are removed was shattered by Brexit.  A great number of people reject this myth. They do not want unrestricted immigration. They want Free/Fair Global Trade based on value for value reciprocal benefits.

People also do not want their societies devastated by unemployment and falling living standards. Some also do not want their proud cultures diminished by excess immigration that chooses not to assimilate. Immigration used to be people coming to assimilate. Today, there is a sense that immigrants are coming to “take over”. This will continue to lead to political strife.

People can love their neighbors and even love their enemies—but that is not the same as inviting neighbors and enemies to come live in and redecorate their homes. It is no surprise that the proud cultures of the US and Great Britain are some of the first places to show organized resistance to a direction toward extreme diversity.

Nothing in Brexit necessarily will reduce Free/Fair Global Trade. Nothing that I can see in the upcoming US election will reduce Free/Fair Global Trade. (One candidate has warned he intends to focus on increasing the “Fair” part along with the “Free” part, but neither candidate is advocating a restriction in Global Trade.)

Hence, the only thing happening today, as the Dow 30 is down 3% is a reaction to the surprise of the result, and concerns about uncertainty of what happens next. Even at the level of 17480 for the Dow 30 as I write this at 1:30PM on 06/24/2016, the market is still UP 11% since February.

Could stock markets fall further? Could they reach the February lows again? Perhaps, but Brexit will not be the only cause. Stock markets are driven by Corporate Profits and Interest Rates. And, investors should not be invested in “markets” but rather a conservative balanced and diversified portfolio of ownership in great companies.

Be cautiously optimistic. Lower prices will create some opportunities. There are a substantial number of great companies with great future prospects—they will prosper even if Great Britain and a few other countries decide to defend their proud cultures by separating politically from the European Union

Friday, April 29, 2016

Will Investment Returns Be Below Historical Norms



The link and graphic is to Bloomberg and a McKinsey Study.

We will be hearing more of this pessimism over the near term. The negative thinking centers on assumptions that: 1) Corporate profits having peaked; 2) Global growth will slow; 3) Interest rates will continue to be low.

In addition to the short term fluctuations in market sentiment (fear vs greed) one must also consider that there are cycles in long term market sentiment.

In my humble opinion, it is unwise to accept the assumptions in this article as having a 100% probability. My assessment is that they have a more than 50% probability of being very wrong.

Perhaps the biggest factor will be the assumption regarding global growth. While the rate may temporarily slow as excess capacity is absorbed in the short term; over the long term, the substantially growing "middle class" in developing countries has not yet come even close to the consumption levels of the average American. Energy, Health Care and Communication have potential future growth rates substantially higher than we have ever seen in the past.

Be cautiously optimistic in the long term.

Long Term Investment Returns Troubling?



Saturday, April 23, 2016

Is it a Bull, a Bear or a Bunny



The symbol of a bull supposedly indicates a rising market. The symbol of a bear indicating a falling market. The symbolism relates that a battling bull engages in conflict by raising his head and horns, while the bear uses his paws and claws to pull down.


People have attempted to predict future market returns by describing current conditions as a Bull Market (rising) or a Bear Market (falling).  A third condition is sometimes calls a "Consolidating" or "Flat" market. 

Keep in mind that assuming that current conditions will continue with "momentum" into the future is a dangerous form of cognitive bias.  It stems from the incorrect application of Newton's First Law of Motion: "Every object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it."


Markets are not objects. Markets are an indication of the consensus view of the likely future. And this consensus view is often strongly influenced by the very real human emotions of fear and greed.

Greed and a "fear of missing out on gains" tends to drive Bull Markets. Fear of loss tends to drive Bear Markets.  Uncertainty tends to create "Flat" Markets. A fourth type of markets could be dubbed a "Bunny Market".  A Bunny Market jumps up and down and is driven by EXTREME uncertainty. Over the longer term, the market does not rise or fall--it just fluctuates.


Arguably, we have been in a Bunny Market for at least two years. 


The EXTREME uncertainty stems, in great part from unprecedented Central Bank interference that continues all over the world. There is no historical indication of what happens when this interference ends and interest rates return to "normal".  In fact, many predict that the old normal is replaced by a new normal where interest rates and inflation will be forever low. 


What is known for sure is that if interest rates do return to the "old" normal, there will be a great deal of economic turmoil.  Governments will have to raise taxes. Durable goods like cars and homes that are often purchased with credit will become more expensive and sales volume will decline. Some businesses that rely on credit will go bankrupt or at the very least will become much less profitable. And, people who have purchased long term government bonds at low interest rates will witness a significant loss of principal. Yikes!


No wonder every word that comes out of the mouths of Central Bankers have an effect on markets.


In addition to the uncertainty about interest rates, there is the uncertainty about the growth of emerging markets--particularly China. And, then there is the issue of oil and gas prices that seem to be greatly influenced by government policy--in Iran, Saudi Arabia and Russia as well as in the USA. 


So, at no time in history, other than perhaps during the World Wars, has the global economy and markets been more reliant on government policies and politics.  


So, the best investment policy is probably (for most people) to limit your exposure to long term fixed income investments and concentrate on owning a very diversified portfolio of stocks in companies that are likely to maintain stability and profitability during times of rising interest rates and/or a slower rate of global economic growth. And, take advantage of the Bunny Market by avoiding the temptation of buying when prices are high---and by having the courage to buy when prices are low.  Be patient. Investing is about the long term.




Please be sure to read the below disclaimer--Your personal portfolio choices should only be made after a complete review and analysis of your risk tolerance and income requirements and only after a discussion with your personal financial advisor.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.