Thursday, May 15, 2014

The "all else" (Part 1)

As you may know, my work requires that I pay attention to the opinions of those who---I have to assume based on the audience they attract---know what they're talking about when it comes to the financial markets and the world economy. Having done what I do for a very long time, it has become abundantly clear that even the presumed "best" in the business can be every bit as much the victims, or the beneficiaries, of their ideologies as the rest of us.

My advice to you, dear reader, when it comes to the opinions of "the rest of us"---that would be your family, friends, office mates and neighbors---is to dismiss the opinions of those with the strongest opinions. Pardon my seeming condescension, but the fist-pounders tend to be the faithful parrots of the personalities who, for example, appear on the only cable TV news network they're willing to watch.

As for the opinions of the "experts" who attract wide audiences, my advice is to dismiss the opinions of those who sound like they know precisely what they're talking about. For they are generally the ones with the strongest one-dimensional convictions. And when we're talking about the global markets, and economy, we're talking about ever-evolving structures with moving parts too numerous to even begin to aggregate, let alone anticipate.

That'll be my segue to today's message:

Yesterday, I performed my semi-monthly valuation analysis of sectors, styles, market caps, non-US developed and emerging markets. As I've been reporting, I don't characterize the overall market as cheap, like I did in early 2013. However, I don't see it---historically-speaking---as expensive either. Broken out by sectors, styles, regions and size, I do find areas that look relatively expensive, a couple that look relatively cheap, and many in the middle. The 18,000-point (as in Dow points) question is, what are corporate earnings going to do going forward? Should they rise from here, all else equal, stocks should continue their climb. Should they decline, all else equal, so should stock prices. The problem is the "all else"---it never stays equal.

So, what would be the "all else"? Well, it's a lot of things---and it's different things to different people. For me (in no particular order) it's the bond market, interest rates, cap-ex spending (business expansion), GDP, the Fed, the Eurozone, the ECB, the UK, the Bank of England, China, the Bank of China, Japan, the Bank of Japan, the emerging markets, retail sales, housing, demographic trends, producer prices, consumer prices, small business sentiment, investor sentiment, commodities prices, short interest (how many are betting big on a drop), margin debt (how many are betting big on a rally), stock sector valuations and 200 day moving averages---and that's the short list. And it's way too much to cover in one blog post.

So here's my plan for the next few weeks: Starting today with bonds, I'm going to offer up a brief---succinct as possible---synopsis, one a day (or so), on each of the above. My aim is to help you put what you're hearing from your favorite news source into what I view is a healthy perspective, and---more importantly---to help you understand how the "all else" (or some of the "all else") can impact your portfolio. As I go along, you'll understand why I prefaced this exercise the way I did. Here goes:

BONDS (AND INTEREST RATES): The Basics: The thing to keep in mind about bonds is that the price an investor pays and the interest rate received move inversely to one another. Using treasury bonds as an example: When the federal government runs a budget deficit and, therefore, must borrow (issue treasury bonds) to pay its bills, investor appetite determines how much the government will have to pay in interest. If the interest rate environment is such that high quality debt is paying, say, 4% annually for a 10 year term, the U.S. Treasury will to be forced to offer a comparable yield on 10 year treasury bonds to attract investors. Rising interest rates---with regard to high quality bonds---generally occur during periods of rising optimism over the prospects for economic growth, or a prevailing fear of higher inflation.

As you may know, the 10 year treasury trades today at a remarkably low 2.54%. So, what does that say about the prospects for the economy? Well, based on what you just read, nothing good. And, indeed, that may be what today's very low yield is telling us about the future. Although, it could also be telling us something else. Below I'll list a few possibilities and their reasonings...

Yields offered by other sovereign issuers are comparable---to lower---than the safer U.S Treasury bond: For example, Germany's 10yr currently yields around 1.3%, France's 1.8%, and Spain's 2.8%. According to CNBC's Rick Santelli, the world's central banks' gobbling up of so much government debt has lessened the global supply relative to demand---making such debt more expensive and, therefore, lower yielding...

Geopolitical angst: Today that means fear over Russia's foray into the Ukraine. Should that conflict lead to serious trade disruptions (think Russia not supplying energy to Germany, etc.), there'll be economic headwinds the world economy doesn't need at the moment. Nervous investors might indeed buy treasuries as a safe port till the storm blows over.

Currency manipulation: There's always that game countries play (while denying it the whole time) to goose their exports (and, in some cases, to inflate away their debt). Converting their own currency to dollars (buying treasuries) lowers its relative value against the dollar and makes their goods more attractive to U.S. consumers.

Pension fund rebalancing: This one's been featured a lot in the press lately and, frankly, I'm not entirely buying it. It goes like this: Pension funds made huge gains last year and came a long way in terms of fixing their highly advertised underfunding issues. Having done so well last year in stocks, they're locking in those profits by selling and moving huge amounts into the safe haven of the ten-year treasury bond.

It's not that I'm not buying the rebalancing story (we've been consistently selling back to equity targets throughout this bull market), it's the buying the treasury bond part. I just can't see investment consultants recommending that their pension clients buy a security at a valuation that offers far greater downside than it does upside risk. We're certainly not rebalancing our pension clients into ten-year treasuries these days.

Huge short interest: Warning! This one's a bit wonky: Every economist in a recent CNBC survey anticipated that interest rates will rise in 2014. Bond traders galore believed the same thing coming into the year. And it made perfect sense: if the economy gains some traction this year, which is (or was) widely expected, surely bond yields will rise---perhaps in a big way. So, if everybody heading into this year was thinking interest rates would rise, how is it that, as of today, they've fallen to last October lows. Wouldn't all those bears sell bonds in anticipation, thus making the rise in interest rates a self-fulfilling prophecy? Well, yeah, but remember, the Fed, foreigners, yield-seekers and fradeycats have all been buying. Plus, the federal budget deficit is about a trillion less than it was a couple of years ago, which means the government doesn't need to issue nearly as many treasury bonds in order to pay its bills---which means less supply. In essence, there have been plenty of buyers to buy up what the bears have been selling---and some.

Now, to compound matters, there's that "short interest": When you're savvy (and gutsy), and you're certain the price of a security is fixin to fall, you "short" it (borrow it [through your broker] then sell it, expecting to buy it back later at a lower price and replace it---pocketing the difference), or you short the exchange traded funds (ETFs) that invest in it, or you short its futures contracts, or you buy put options on the ETFs that invest in it (I'll stop there). When we're talking bonds, you're expecting to hit a grand slam with such strategies when interest rates spike and bond prices tank. Oh, but if you're wrong, and the price moves higher instead, you get creamed. If the price moves way higher, you get way creamed. So, when the price moves against your position, and, in the case of bonds, you fear a 1.50% handle on the ten year treasury, you---in the case of shorting---cover your shorts (buy back those bonds at a higher price than you sold them for) and lose the difference. And of course all that short covering (buying) serves to exacerbate the upward momentum in bond prices and the downward momentum in interest rates.


While listening to a Bloomberg radio interview replay last evening---the topic being the bond market---I began to wonder if we're not about to come full circle. The guest was explaining pretty much what I've been hearing from a hoard of "experts" over the past few days; "that everybody's been wrong about bonds". "That the year's half over and, contrary to what everybody thought would occur, interest rates have been going nowhere but down---and that's where they're staying for the balance of this year."

Now, if you believe, as I do, that when an opinion starts to become crowded---when a strong consensus builds---opportunities emerge on those roads less traveled (where the crowd ain't), you expect that the bond market may soon be sending those "experts"---who are predicting low interest rates as far as their eyes can see---straight to their optometrists. In other words: should this downward move in yields make converts out of all those bears---if they finally capitulate and join the bulls---that (once the piling-in rally subsides) is when I suspect we'll see interest rates finally begin to spike and bond prices to fall---which is when you and I will, at last, find opportunities to add bonds to our portfolios.

As for those fist-pounding "experts"---the one's on TV and the one in the cubicle next to yours---if they believe today's low interest rates are 100% about the sluggish economy, they very likely possess a strong political conviction (doesn't mean they're wrong btw). As for me, I believe it's a combination of the above. I mean, surely, some are buying out of fear over the economy, some because treasury yields are higher than German bund yields, some because they're anxious about the Ukraine, some because they're trying to cheapen their home currency, some (few, let's hope) because they're rebalancing their pension portfolios, and some because they're bailing out of their short positions.

As for bonds and the stock market, the question is, how will stocks hold up when bond prices finally begin to come down? Good question!

I'll be back...


  1. […] Click here for part 1, here for part 2 or this series. […]

  2. […] 10 of my “All Else” series is a no-brainer. Why would I, an investment consultant, concern myself with retail sales, or, […]

  3. […] market (prices remaining high)—as an economic forecaster (high bond prices denote pessimism [although other factors were/are in play])—got it […]