Archive for July, 2013

Bond, Treasury Bond

Wednesday, July 31st, 2013

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Over the past 30 years, the policy of our Federal Reserve has been to lower interest rates as the risk of inflation has decreased. Many of us with a wee bit of gray at our temples remember Paul Volker raising rates to combat the 1970’s inflation that stemmed from wrong-headed fiscal and monetary policy decisions made by governments starting after Kennedy and ending before Reagan – Ford gets a big pass because he (a) wasn’t there long enough to make an impact either way; (b) kept our country from falling into a third-world style vendetta of revenge against Nixon (much the same can be said for Mandela and his policies in the aftermath of the Afrikaners – what ever happened to classy guys like those running countries? The world is sorely in need of that at the moment); and (c) came up with the nifty Whip Inflation Now slogan and its ubiquitous WIN buttons. But, I digress…

Those rate cuts brought on a secular bond bull market that you can see on the chart above that traded in a consistent upward bound range from 1982 to present.

There is a lot of talk that the bull market ended last summer (you can see that the high point on the chart was mid 2012 and since that time the bond market has been moving from the top of that 30-year range to the bottom of it). Their basis for this is that bond yields hit their lowest levels several months ago and Europe is recovering (so the rush to safety trade is past).

I can buy into this theory, but given that we are still within the trading range – and until we fall below the bottom blue line – we can’t state for a certainty that the bull market is over. Over the past 30 years, this trading range has held and the bond market has moved up and down within the range as macro forces impacted it.

The biggest impact on bond prices is the change in interest rates. This is investment management 101 – rates up mean prices down. So, the chart below shows that move in interest rates.

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When you look at this chart, you see where rates bottomed last summer, as the theorists who believe the bull market is done have stated. You can also see that rates skyrocketed in May when investors heard the Federal Reserve Chairman state that their bond buying/money printing was on borrowed time.

But, interest rates generally move in relation to inflation. Check out this chart (its from Google images – I didn’t create it but can provide a source for it, either – if you created it, this blog thanks you!):

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You can see that as inflation has moved down over the years interest rates have also moved down in a similar pattern. But, the move higher in rates since last summer has not been due to increases in inflation, but rather something else is going on – bond investors’ assessment of the risk to their principal from investing in Treasury Bonds.

The chart below shows you the performance of intermediate US Treasury Bonds to Junk Bonds (as represented by two applicable mutual funds) since the Fed adopted their policy of buying treasury bonds. Its pretty tough to infer that junk bonds are more risky than treasury bonds from this chart – in fact, junk bonds (the red line) looks less volatile and held their value far better than treasury bonds (the dark blue line) in the period since rates started rising.

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The Fed’s stated policy has been to increase the value of “risk” assets in order to provide a wealth effect and make consumers spend/consume more as a strategy to kick our economy into higher gear. Asset values have gone up, but the economy is limping along at a roughly 1.4% GDP growth rate for the first half of the year.

Unfortunately, what this policy is doing is driving investors out of safe assets, like certificates of deposit, treasury notes, and high quality corporate bonds (which are yielding very little) into the stock market and into junk bonds (and other esoteric investments that they don’t understand) which yield more. This is a really bad thing, but they are looking at the risk as being the same between the safe investments and the extremely risky ones so why not go for the risky ones with the higher yield.

But check this out:

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This is the same graph comparing intermediate treasuries to junk bonds, except over a 20 year time frame. When you expand the data set, you can clearly see that junk bonds are called junk for a reason – there are periods of significant loss on that red line that would devastate most investors who are really savers and inherently risk averse. Unfortunately, the Fed’s actions are manipulating the bond market (and the stock market but that’s a discussion for another time) and in particular the riskiest part of the bond market, to appear less risky than it truly is.

What these investors will find is that the money they rely on to support their lives will be gone – potentially gone for a long time if they are in unhedged mutual funds or more esoteric investments – when we move from a secular bond bull market to a secular bond bear market.

There is a fundamental difference between owning a mutual fund with no maturity date and a corporate bond with a fixed maturity. If you own an intermediate term bond mutual fund and interest rates go up, your fund (if unhedged) will go down. And since there is no maturity date on the fund, it can stay down for years as the underlying assets grind on until they mature (if the fund manager holds them until that time) – not something most investors understand.

Individual corporate bonds, on the other hand have a fixed maturity date. If you buy a two or three year IBM bond and pay $5000 for it, at maturity you get your $5000 back to reinvest – and if you are in a rising rate time period, you get to reinvest all of your money back into a new bond at the higher rate. Its a pretty good deal and the best strategy a fixed income investor can adopt in a bond bear market.

So, in keeping with our standard risk management practices, we have begun to move out of the diversified fixed income mutual fund portfolio we have used for several years, into a portfolio that is structured as follows:

1. If the fixed income portion of a portfolio is large enough to justify owning individual bonds, we take roughly 1/2 the portfolio and build a maturity ladder of high quality corporate bonds with fixed maturities between one and five years. This way, as interest rates rise, we are able to reinvest the bond proceeds at ever-higher rates as we move through the potential bond bear market.

[the strange thing is that we could have the first bond bear market in our history that does not involve rising inflation, but have rising interest rates due to bond investors fear that all of the accumulating debt our government is taking on makes their credit worthiness less than it should be]

2. Of the remaining 1/2 (or if the portfolio is too small for individual bonds, then the entire fixed income allocation) is shifted to favor adjustable rate bonds (split 40% to adjustable rage corporate securities and 60% to adjustable rate AAA government securities) with the balance of the mutual fund exposure in short term/duration bonds and slightly longer duration hedged bond funds.

In a falling rate environment, mutual funds that have a longer duration than you would use when owning individual bonds, tend to provide you with capital appreciation and higher income. Unfortunately, in a rising rate environment, you experience capital loss that tends to exceed your income. Knowing and understanding this simple fact is one of the tricks of the trade – every investment has its time and place. The time for bond funds potentially has passed and the time for individual bonds appears to have arrived.

I started my career at the tail end of the last bond bear market – I remember the 14% 30-year treasury bond and wish that more people had dropped their entire investment portfolio into them. But, most people in the investment business now are younger than me and only know the bond bull market. Most can’t imagine a 14% treasury bond let alone a bond fund with capital losses – things are going to be very interesting, and expensive, for many people who should own CD’s and not some closed-end junk bond fund (with a user-friendly name like High Income Fund).

It will be interesting to see if all of these people that are being advised by their investment managers to buy the risky investments (those that will be hurt the most by rising rates) will surrender to the bear and work to them out of it before the worst of the damage is done or if they will ride them much much lower. Its an academic question, and one that might seem more than a little bit weird, but answers to questions like these provide patterns of human behavior that help guide future decisions for investment professionals.

Anyway, have a good night.


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Mark

Reflections on the Market

Tuesday, July 30th, 2013

Index Indicators

Click on the chart for a larger view

I haven’t posted this chart in a long time, but thought it would give you a feel for some of the market internals that have me concerned.

Although it is not included in this chart, the S&P 500 is still trading greater than 10% above the 200-day moving average – an area that I’ve written about a lot here on the blog. What I do have to show you is a longer-term version of this chart that covers the entire secular bear market of the past 15 years.

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This chart gives you a feel for the price of the S&P 500 compared to its 200-Week moving average (the red line), with the two blue bands representing the price 25% above and below the average. Its easy to spot when the market gets euphoric and trades at or above the top line: the late 90’s when valuations got completely out of sync with reality as so many people were quitting their jobs to become day traders because the market could only go up; 2007 before the sub-prime mortgage crash; and today we are back above the blue line due to the monetary stimulus (aka, money printing) by the Federal Reserve that again has everyone believing that as long as they keep the presses cranking, stocks will only go up.

But, lets get back to the top chart.

The middle section of the three is the one that is the most telling for me. This section shows the NYSE Composite Index (the gray bars) overlaid with the Summation Index (the red line) and its 5-day moving average (the blue line). You can see that the red line has rolled over and is about to cross the blue line. When this happens, it historically is a leading indicator for a pullback in the stock market. Sometimes its a few percentage points and sometimes its much more.

To get a feel for how big of a pullback, you need to look at the top and bottom sections of the chart for confirmation. The top section shows the relative strength index for the NYSE Composite Index – you can see that this indicator is falling pretty sharply. The bottom section of the chart is the graph of the McClellan Oscillator – the easiest way to understand it is that it’s the short-term version of the Summation Index.

Both the Summation Index and the McClellan Oscillator measure the breadth of the market, based upon the relationship of stocks advancing in price compared to those declining in price. It is an oddity of the way the market indices are calculated that they can still be going up even when more companies are falling in price than increasing in price. Eventually, as more and more companies fall in price than go up, the market indices start to reflect that. These two measures can help you spot changes in market direction before they show up in the S&P 500 Index, the NYSE Composite, or the NASDAQ, to name a few popular indices.

So, I’d look for the market to pull back at some point soon – the question of course is how far. A case can be made that the market is just getting exhausted based upon an examination of trading volume – during the move higher from the June lows, volume has been less than its 50-day moving average. You can see that in the graph below:

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The red and green bars at the bottom of the chart show you the daily volume with the blue line representing the moving average. What is more interesting, though, is the black line that was trending up but has flattened out in the past week. That line is the On Balance Volume line and represents a cumulative measure of up-day volume less down-day volume. It is a good representation of what the institutional money flow is doing, and if we are starting to see a flattening that might lead to the downturn in this indicator, then there will be less money bidding stock prices up.

The top part of that graph is just the daily price candles with several short term moving averages. If you squint, you can see that we are now trading below the 8-day moving average and starting to test the 13-day moving average – more signs that market is weakening, although a move back above the 8-day would indicate a continuation of the recent up-move from the June lows.

So, what this means is that we are sticking with the plan I wrote about here: we have stop losses set on a number of holdings that we classify as sale candidates based upon either a deterioration of their fundamentals (eg, earnings growth is slowing or macro forces are impacting their future) or their valuation has gotten ahead of their earnings and we now classify them as expensive.

We have also identified purchases that we will execute after the market pulls back (if it does pull back as the indicators are telling us) so that we can continue to get money into the market at reasonable levels. The tell for us on when to pull the trigger on the buys will be when the indicators that pointed to a down move change direction and point to an up move.

Remember – invest what you see not what you believe. You might believe the market can only go up with all of this Fed money printing, but believe what you see happening to the prices of stocks – and right now I see more stocks declining in value than increasing in value.

We have also been working on changes to our fixed income portfolios which I’ll write about in a day or two (subject to how my week goes) before I leave for a few days of whitewater rafting.

Enjoy the cool weather and I’ll be back, soon!


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Mark

PS – Florence Ballard is no relation…Click to find out more about her

What’s New Peoria CAT? China Woe-Woe-Woes

Wednesday, July 24th, 2013

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Double click the chart above for a larger version

Its rare that I agree with CNBC reporters, but today one stated that Caterpillar has become very bad at forecasting their earnings. Today’s earnings report wherein CAT blames the slow economic growth in China for their missing their own earnings forecast leaves me in agreement. And because I have lost faith in their announcements, I will be liquidating our holdings of CAT once we get some price stability.

But, lets look at the chart above so you can see what I see.

First, the stock price is down 2.43% today due to the earnings miss. You can see that the price hasn’t made it all the way back down to that series of lows on the graph in the $79-$80 range, but it appears headed that way from its current $83 and change.

Next, look at the Relative Strength Index at the top (RSI7). According to this measure, it is not even oversold yet, which generally indicates that if the trend has shifted to down, we should see lower prices ahead.

In the Volume section of the chart just below the price graph, you will see a jagged black line that is trending downward – that is the On Balance Volume line and is an indicator of how buying and selling volume reacts to price. In this case you can see that the trend is for sellers to be more active as price falls – a bad sign for the near-term price of this company.

Similarly, the CMF (Chaikin Money Flow) section of the graph below that with shows that the institutional money is flowing out of the stock (see the histogram in the middle that is reading below the mid-point) and the Accumulation/Distribution line is trending down showing more sellers than buyers are bellying up to the bar.

The Full STO graph below that (Full Stochastics) is a short-term trend indicator which shows that we have just moved from Overbought status, and it’s pointing to more selling ahead.

The MACD graph below that (Moving Average Convergence Divergence) is an intermediate trend indicator, and when the black line crosses the red line, it points to a change in intermediate term trend. You can see we are at the crossing point which indicates the trend in this stock’s price is about to move down.

The graph below that shows you how closely CAT’s price has moved in correlation with the S&P 500 Index over the past year. Currently, CAT’s price movement is 88% correlated with the S&P 500 – one way to look at that is to say that 88% of CAT’s price change is caused by the movement of the overall market. Unfortunately for CAT, the other 12% has been down.

And the final section of this chart is a graph of CAT’s price performance over the past 12 months. You can see that over the last year, CAT is up 3.59% even after today’s loss – still better than a Treasury Bond, but not enough to compensate you for a required equity premium for taking on the risk of investing in a stock.

So, I will be a seller of Caterpillar soon. Hopefully we see a bounce in the price tomorrow as (other) suckers who haven’t yet learned the lesson of their poor financial forecasting will take our shares off my hands at a price higher than today’s close.

Lesson learned…


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Mark

Second Quarter Update

Thursday, July 11th, 2013

2nd Quarter 2013

Click on the graphic for a bigger/less distorted view of the charts in this blog post

U.S. stocks sold off during the final weeks of the second quarter with large cap stocks performing worse than small caps in the correction. Weakness in foreign stock markets, notably Japan and China, also negatively impacted U.S. markets – and sent the EFA and Emerging Markets indices down significantly.

The bar chart above shows you that large cap stocks, which had been rising faster than other asset classes over the past couple of years, ended the quarter up just a bit under 3% – well off of where it was in Mid-May – with small cap stocks performing better than 4%. You can also see the damage that was done in the foreign, gold and bond markets, with the surprising result that US Treasury Bonds lost 4.21% during the quarter while Junk Bonds only fell 2.59%.

Federal Reserve comments related to the timing of the end of its bond buying stimulus drove U.S. stock prices lower and bond yields higher (which pushes down bond prices). The money printing activities of the Fed since the beginning of its Quantitative Easing programs have pushed stock prices higher and bond yields lower, all to the benefit of investors. Any threat that this easy money policy is nearing an end will be detrimental to stocks and bonds, just like June’s sneak-peak demonstrated.

From an economic standpoint, June’s reports were conflicting. Manufacturing growth slowed in May, however, car sales and durable goods orders both showed increases. Service sector employment growth slowed, yet, initial jobless claims were lower. New home sales and pending home sales both pointed to continued strength in housing even as mortgage rates rose.

In a change from the past few years, investors tended to favor the stock of smaller companies exhibiting growth characteristics over companies exhibiting value characteristics.
June Performance Chart

You can see that Large Cap Growth continues to be the worst performing asset class, but Mid and Small Cap Growth performed significantly better than Mid and Small Cap Value companies. Large Cap Growth should begin to follow its smaller cap cousins into better returns in due course.

Our stock investment methodology is a growth-based methodology, rewarding such factors as earnings growth, increasing cash flow from operations, and return on equity. These are the metrics that the owners and managers of businesses watch to make sure their companies are performing at peak levels, and it is also – over the long-term – the key to stock price out-performance.

You will always have times where a value-based and/or dividend-income methodology will outperform growth, but over a lifetime of investing, a growth-based methodology provides better results because ultimately growing earnings equate to growing stock prices. Needless to say, I am happy to see the market begin to reward growth characteristics once again, even though the Large Cap Growth class has yet to participate.

Stock performance of industry groups varied greatly during June. Top performing industries were related to the consumer – both consumer staples and particularly consumer cyclicals had good months; among the worst performing groups were the materials – gold, metals and mining, copper and aluminum – and technology, both of which tend to forecast a slowing of worldwide economic activity. The technology sector performance also explains the performance of the Large Cap Growth asset class.

From a strategic standpoint, we used the sell-off in the stock market during May and June to put a significant portion of the cash we had on-hand back into the market.

S&P 500 with 200 Day Moving Average

As the S&P 500 Index sold off to a level below the 50-day moving average near month-end June (the red line on the chart above), we used the lower prices to buy well-run companies 8% to 20% or more below recent highs reached this Spring. You will see many of these purchases in your statement this month, but many others did not settle until early July.

Today, the market has moved back to the blue band which represents a level 10% above the 200-day moving average – a typical danger zone for the stock market. Our plan now is to utilize a trailing stop-losses strategy that will protect gains in our holdings as the market tries to retake earlier highs above that blue band, automatically raise cash when we sell-off again, and then reinvest that cash at lower prices. This is the most prudent risk management strategy we can employ at this point and still participate in the market dominated by the Fed’s money-printing induced run higher.

It seems simple, but in practice it is as much art as science in determining what price level to set the trailing stops so that you do not sell on a false pull-back leaving you stuck with cash. Also, determining when to reinvest the cash back into the market during a correction, buying selected companies with solid earnings growth/returns/cash flow, so that you are not too early or too late requires the proper analysis.

We utilize technical analysis of the market to help us determine changes in the sentiment of the investing public in order to point to directional changes in the indices for buy and sell points. Regular readers of this blog are familiar with many of them but new readers can easily read prior articles to get a feel for it.

As things change in the market or as other issues arise that need explanation, I’ll be back with updates. But until then, enjoy this “Sweet” hit from the 70’s British Invasion (pun obviously intended).


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Mark