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What To Do With An Over-Valued Market

October 29th, 2017

NASDAQ CrashesDouble click on any image for a full sized view

I have been very skeptical about this market for a very long time. With valuations stretched above the 95th percentile and complacency running rampant with investors, professional and individual, the risk of being in the market is high.  However, nothing says that this situation cannot go on for a long time into the future before stock prices revert to the mean.

My clients’ cash equivalent allocations in their portfolio are at their max level allowable by policy, so I have been working on booking profits in some high beta holdings (ie, the more volatile ones that have been screaming higher) and moving into things that have been beaten down or haven’t participated in the recent run up, like retail.

I now have a market weight allocation in retail in client accounts, but to get there I had to buy things like Tractor Supply (which I initially had a loss in but now a nice profit), TJ Max, Ross Stores, and Home Depot – companies that seem to be able to weather the Amazon juggernaught.  In income accounts, I bought a couple of companies that were smashed by the Amazon-induced retail bear market, Kohls and Nordstroms (Kohls I have a nice profit but the headline news in Nordstroms has kept that one down). However, I don’t think that is enough to keep portfolio values up if we get a solid correction in the momentum tech companies. So I wanted to share the next step in the strategy I am beginning to put into place.

When we went through the 1999 stock market melt up with the NASDAQ stocks hitting unimaginably high P/E valuations, one of the things I did to prepare for the inevitable fall back to earth was to pick an asset class or industry that was just the opposite from the momentum companies in terms of being in a bear market while the dot.coms were in a bull market.

In analyzing the dot.coms, you saw that people were throwing money at concepts that had no tangible value. The most opposite asset class or industry that I could come up with was the oil industry. It had been going through a mega bear market with oil dropping to $10 a barrel and companies going out of business. I started to accumulate oil companies very cheaply and reducing tech sector exposure.

By over-weighting the energy sector, when the crash happened, my clients portfolios were protected by the rush into deep value investments like oil companies. By maintaining the overall equity allocation, they were able to participate in the upside during 1999 until the crash in 2000, but because they were in the opposite industry to tech – an industry that had already been in a bear market – they were able to recover from an initial market-wide sell-off while the tech investors continued to be underwater.   You can see the chart below comparing the performance of oil to the NASDAQ from 1999 to 2006.


Today, we have the mobile Internet companies, the cloud companies, and the e-commerce companies that have skyrocketed in valuation. At some point we will need to reduce our exposure to those industries and invest in the opposite industry. Since the Ag industry and commodities have been in a bear market since 2011, it is a natural place to begin – take a look at the graph below.


I added a 1% Potash position this week to client accounts to begin our move to overweight the Ag industry. I will also likely start a position in the commodity fund DBA and begin to search for other suitable investments that have been left behind.

Are there other similar industries to Ag? Well, energy seems to be a viable candidate again:


Maybe this is finally the time for the “Scarcity of Water” theme to play out, too. Given all of the droughts around the world, I thought it would be a winner – but until earlier this year when my research came across he company Xylem the theme just wasn’t playing out as I thought it would.

The mining industry also seems to fit the bill.


Anyway, I understand this is a contrary idea, but since it has worked for me in the past and the current momentum push higher reminds of the dot.coms, dusting off the old invest-in-the-opposite playbook seems as wise as anything else that allows us to stay invested but reduces risk.

Being prudent and protecting hard won gains is critical to long-term investment performance.  Its not the end of the world if the market goes down, but managing through the ups and downs of the investment cycle is always better than being caught by surprise with a huge down swing if you haven’t prepared for it.


Is the Stock Market Overvalued?

July 19th, 2017


Double click any image for a full sized view

It has been eight years since the 2008 stock market crash bottomed and the current bull market began.  There have been a couple of corrections along the way, even a couple of double digit ones, but all in all it has been a fairly straight move up.

We can discuss some of the reasons for this, but it has been engineered to a large extent by the Federal Reserve and their money printing activities (called Quantitative Easing – a process of buying bonds with newly created money).  That liquidity has been used by corporate America to buy back shares of stock (as opposed to investing in research and development or expanding operations) which has pushed the market forward in a fairly consistent manner.  In its simplest from, its Supply and Demand – as long as corporate America has the demand to buy back their own stock and the supply of shares is limited to what people are willing to sell, there is always an upward pressure on stock prices.

The Federal Reserve has been raising interest rates for the past several months, which has begun to curtail liquidity.  However they are about to embark on a reversal of their money printing activities – possibly as soon as September.  In essence, they will be flooding the bond market with government bonds hoping to suck up excess cash that has been flowing into the stock market over the past eight years.  This process (called Quantitative Tightening) simply sells bonds into the market and the money they receive for them is retired from the system.

This is a really big deal and you are likely not hearing much about it.  But from a logic standpoint, if flooding the system with money led to the stock market going up due to a consistent buyer willing to pay market price for their own stock, then logically starving the system of money will remove the principal buyer of stock and send the market down.

How far?  Clearly since this is new territory for all of us, there is no way to know for sure.  But realistically, any over-valuation in the market will likely be erased and potentially, depending upon investors’ emotions, a correction could go further than that.

So I thought it was time to break out my trusty S&P 500 Fair Value Calculators to see what sort of exposure we might have.  Lets check out the Ratio Based version:

Fair Value Ratio

This version is based upon the theory that everything eventually reverts to the mean.  It compares current readings of the S&P 500 – like earnings, sales, and book value – to historic median valuation levels for the S&P 500.  This shows what the index would be valued at using current numbers but historically typical valuation levels.

This calculation uses a weighted average of the various ratios – in the graphic above, you can see that there are two calculations.  One of calculations is an outlier so the first column underweights that one with a 10% weight and the other one gives it 0% weight.   For simplicity sake, we will say that the ratio based analysis tells us that the S&P 500 is 13% to 15%  over-valued.

But lets take it one step further.  Below is a discounted earnings based valuation of the S&P 500.  The earnings estimate comes from Standard & Poors and is a bottom up GAAP estimate of all 500 companies in the index projected through 12/31/2018.  The growth rate is the actual 2017 growth rate and the discount rate is a calculated number based upon the historic S&P 500 return since 1950 + the rate of inflation + the increase in GDP (the calculation is shown as Discount Rate Two).   I have disregarded the alternate version of the discount rate calculation that is an interest rate based calculation ( shown as Discount Rate One) given the artificially low level of interest rates.

Fair Value Disctd Earnings

This discounted earnings calculation uses a ten year period of earnings growth at current rates and a an earnings growth rate of 2% into perpetuity.

Based upon the calculation, we show an over-valuation of over 7%, which is half the ratio based valuation result.

Which is correct?  Realistically you cannot look at it that way.  Each of the calculations could be changed with a different selection of data that would give higher or lower results.  The real benefit of this sort of calculation is to give us a feel for whether the market is over or under valued based upon some reasonable set of assumptions about the future using current data about the market.  We can reasonable say that the market is over-valued by 7% to 15% and that any correction we might have (in September or otherwise) would be within that range – and absent some other factor we are not considering, we should not have a crash like we had in 2008.

So, given the uncertainly in the market’s potential reaction to the Fed’s September Quantitative Tightening, I am comfortable with the conservative position we have in client portfolios with cash and short term bonds on hand.  That will give us liquidity to buy shares of our favorite companies a lower prices than currently available.  Until then we just need to have some patience…

and show some smarts.


2017 First Half Update

July 13th, 2017

00Double click any image for a full sized view

We are halfway through 2017, and it’s been a good six months for stock markets at home and abroad.

Year to date, international stocks have enjoyed the highest performance, with emerging markets showing double digit returns based primarily on the falling dollar, which was down over 5% year-to-date.  Since most emerging market countries peg their currency to the dollar, when the dollar falls, their currency falls and the companies in those countries being primarily exporters enjoy higher net earnings due to the falling exchange rate.

In terms of the US stock market, large cap companies significantly outperformed small cap companies and growth stocks outperformed value stocks during the first half of the year.  You can see a summary of first half returns in the image above.


When we examine the month of June, the tables turned on the first half winners.
U.S. small caps made up for their relative weakness earlier in the year by having the strongest returns, significantly besting large cap stocks.  Growth stocks were thumped by value stocks while international stocks were mixed in June, with developed-market stocks down and emerging markets up.  You can see these returns in the image above.

Bonds are positive for the year but they experienced a negative return in June as yields rose late in the month.

The most striking thing noted during the first half of the year is the low level of volatility in the markets. June had zero days on which the S&P 500 moved by more than +/-1%. Such movement has happened on only four days this year, which is a material contrast to the volatile first half of 2016.


The image above is a graph of the VIX Volatility Index since the year 2000.  The VIX is the red line and the S&P 500 is the blue line.  You can see the inverse relationship between the two indices – the VIX typically leads the S&P 500.  A low level on the VIX indicates complacency in investors – a high level on the VIX indicates fear in investors.

There was only one other time since 2000 that the VIX has been at 10 or below and that was leading up to the 2008 crash.  This image does not say we will have a crash, but rather it just flashes a warning sign that investors have gotten too complacent and they are not prepared for a correction.

The eight-year bull market we have seen in the stock market since the March 2009 post-crash bottom is getting long in the tooth.  Many of the things that you saw in the first half of the year are typical of aging markets that are readying for a correction:

·    The low economic growth we have seen in the face of rising interest rates pushes investors toward growth stocks that have earnings growth in spite of weak economic times, and growth companies do it with little debt to be impacted by rising rates;

·    Investors favor less volatile large cap companies as they see markets moving toward a top over more volatile small cap companies; and

·    Complacency settles in with investors who have gotten used to markets drifting higher and they do not sell when valuations are high.


The image above compares the Fed Funds Rate (the overnight lending rate controlled by the Federal Reserve) to the S&P 500 Index.  The Fed Funds Rate is in black and the S&P 500 is in blue.  This graph is again from 1998 forward and I wanted you to see the relationship between interest rates and stock prices.  The oldest date for Fed Funds Target Rate in my data service is 1998, but I think you can see the relationship between rising and falling Fed Funds Target Rates and the S&P 500 Index.

Again, there is nothing in this chart that says a correction is imminent.   However, the relationship between rising rates and an eventual correction in stock prices is pretty clear.

We have written to you many times that as valuations on companies move further from their averages, risk increases within stock portfolios.  As risk increases, the prudent thing to do is to employ classic risk management techniques, like increase liquidity in the portfolios and, cull the weakest companies from the portfolio, and book profits on winning positions.

We have been using each of these strategies and feel we have adequate liquidity on hand in preparation for the next correction so that we can be a buyer when others who did not prepare for the correction are forced to sell at lower prices.  Remember, investing is not a linear activity like earning interest on a certificate of deposit.  You want to buy companies when they are low priced and sell them when they are high priced – that does not happen within the constraints of a 12-month calendar nor are the starting points nor ending points clearly delineated.

Greed often leads people to hold onto companies too long and miss a selling opportunity in the hope or assumption that prices will go ever higher.

Unfortunately, with rising interest rates, tepid corporate earnings, slow economic growth, and valuations that are above the 95th percentile, now is the time to be prudent before prices come under pressure so that we can be aggressive buyers when the opportunity presents itself.


Bizarro (Investment) World

June 16th, 2017

In analyzing the current state of the financial markets/investment world, my mind settled onto some major issues that should be impacting the stock markets but currently are not:  (1) Rising Interest Rates; (2) Increased Risk Assumed by Investors; and (3) Equity Valuations.

Rising Interest Rates

  • The Federal Reserve raised the fed funds rate Wednesday by 25bps to 1.25% –  the stock and bond market mostly shrugged it off since it was highly anticipated
  • The Fed also announced that there will likely be another rate hike “relatively soon” and that they were going to start reducing the size of their balance sheet by the end of this year by $50 billion per month
  • Coincidently, all of the other Central Banks around the world are also starting to tighten their monetary policy

Normally, this would spook the stock and bond markets, sending both stock and bond prices lower.  Higher interest rates impact corporate earnings in a negative way, and lower earnings lead to lower stock prices.   However, we are not in a normal market any longer.

Increase Risk Assumed by Investors

There was a study that I read earlier this week that showed only 10% of the trading volume in the stock market is currently being transacted by money managers actively managing money:

  • 90% of the trading happening in the stock market is now through hedge fund program trading, index funds, and etf’s
  • Additionally, we have record levels of margin debt outstanding

Given that so many investors are now locked into passive investment strategies, there is no one actively employing Risk Management techniques like we and other active investment managers do.  Passive strategies do not raise cash as valuations and risks rise.  Passive strategies do not sell high beta stocks when they have had significant runs higher to protect the gains.  Passive investment strategies do not re-position portfolios to emphasize defensive or undervalued sectors when economic conditions that negatively impact the earnings of companies present themselves.

Record high levels of margin debt have historically shown that investors are too enthusiastic and not paying attention to the fundamentals.  When the market goes south, the margin debt can wipe out their investments and they then have no assets to ride the recovery higher.

Equity Valuations

Given the relentless upward movement in stock prices, and in an effort to find companies that are undervalued to add to client portfolios, I recently valued all of the holdings in the S&P 1500 using my discounted cash flow model (using Free Cash Flow as the input) and compared the resulting intrinsic value to current prices. The findings were quite instructive:

  • Taken as a group, the companies are collectively 40% over-valued
  • 310 of the companies were undervalued
  • Of these, the predominant number were Financial Services, Energy and Retail
  • One company’s DCF value and price were exactly the same
  • 1,189 companies were overvalued
  • Of these, the predominant number were Technology, Aerospace/Defense, Heavy Construction, and Biotech  (one caveat about a strict DCF using FCF, many growth companies in the tech and biotech industries do not have free cash flow as they are constantly reinvesting for growth – this can negatively impact the calculation of their intrinsic value and likely has skewed the results  – meaning the 40% over-valued result is somewhat less – when I have time I plan to repeat the exercise with EBITDA instead of FCF to check the results)
  • Not surprisingly, when I calculated the Forward Rate of Return for each company, the undervalued companies’ FRR were predominantly in the double digits
  • The overvalued companies’ FRR were predominantly in the single digits or negative
  • When I made the comparison of the 1500 companies’ Price-to-Earnings, Price-to-Book-Value, and Price-to-Sales Ratios to their 10-year median values for each ratio, I was surprised by the extent of the companies that were overvalued on these metrics
  • Only about 350 companies have ratios less than their 10-year median values, and only about 100 of them were showing undervalued on all three ratios
  • Those most consistently overvalued based upon the ratio analysis were also overvalued on the DCF analysis; those most consistently undervalued based upon the ratio analysis were also undervalued on the DCF analysis
  • When I compared the companies’ PEG Ratios to our benchmarks (1.2 preferred and 2.0 tops) I was pleasantly surprised by the number of companies that passed these benchmarks.
  • Even though P/E’s were predominantly higher than their 10-year median levels, earnings growth had to have also been higher, making the higher P/E’s more palatable

With rising interest rates on a global basis, the macro economic picture is deteriorating. Combine this with investors’ assuming more risk than is warranted for the current stage of the cycle, and equity valuations on average well above fair value, now is the time for caution and prudent risk management – NOT aggressive buying of equities or of trusting your investments to a passive strategy with no one working on your behalf.

  • Statistically, the portfolio that is cautious when the markets are overvalued and aggressive when they are undervalued significantly outperforms other styles of management including passive index styles and buy-high-sell-low
  • It can be difficult for an investor, professional or otherwise, to maintain prudent risk management standards in the face of the hype over index funds and etf’s and the hype of the high flying stocks in hot but overvalued market
  • Investing is a marathon and not a sprint – what really matters is that our clients have the largest pot of money possible when they need it (retirement is a big one) and not following the latest fad that wins in the short-term but causes the client to lose in the long-term
  • Stock market returns do not come in a straight line.  Stock market returns are not like receiving interest on a CD or a bond.  Active investment managers can book profits and raise cash when valuations get too high then use that cash to buy back shares when corrections happen.  Passive investment strategies ensure that you lose money in the correction and wait for the recovery only to get back to where you started.

I do not know when this market will roll over and correct.  There is no way to know what the catalyst for the pullback will be.  However, when it happens, I and other active investment managers who have cash on hand to purchase stock in great companies at a significantly reduced valuation will be almost as happy as our/their clients when the correction subsides and stock prices resume their march higher.

When that happens and we turn the page on this investment cycle, this Bizarro (Investment) World where prices continue higher in spite of materially negative issues will revert to an Investment World where earnings, cash flow, and valuations matter.  And I will be happy to see that happen.

Investment management is risky business and it is always best to trust a professional to deal with the complexities of generating and protecting wealth.

Here is something from this century for those of you reading this who weren’t alive in the early 80’s and may have never seen Risky Business:

And for those of you that wanted a full Bob Seger video, here is my favorite:



“Never A Borrower Nor A Lender Be”

May 3rd, 2017

Screen Shot 2017-05-03 at 7.56.43 PM

Double click on any image for a full sized view

I ran across this graph of the total debt in our country and I was astounded.  The graph from Yardeni and Assoc shows that our nation has total debt of nearly $70 Trillion.

I had to stop and think about how much a trillion dollars actually is since my checking account is a few zeros shy of that number.

Look at it this way, if you were to spend $115 Billion every hour of every day of one year, you will have roughly spent $1 Trillion.  In 2016, the US government added $1.4 Trillion to the national debt, which now stands just shy of $20 Trillion.  If you look at it from a per person standpoint in our country, each person owes $60,000 to cover the outstanding debt – or a family of four owes nearly a quarter of a million dollars.

How can that ever be repaid???

When you add in the other debt, from states and municipalities, from corporations, from consumers, etc, you total $70 Billion.  Its too depressing to think about because there is absolutely no way it will ever get paid off.  We as a nation are collectively bankrupt – and the deferred liabilities like unfunded Pension and Healthcare Obligations of the US Gov’t of $20 Trillion (per the Business Insider) plus state municipal pension obligations of $1.75 Trillion (per CNBC) and corporate unfunded pension liability of $3.79 Trillion (per the California Policy Center) and we have a nearly $100 Trillion problem.

The only way out of this is to continue to print money so that the debt is paid back in severely deflated dollars.  Demographics will not allow for adequate population growth to ensure GDP grows at a +4% level, so inflation is the only answer – or such a severe depression that all the debt is wiped out but I am not ready for a Road Warrior type of lifestyle.

Screen Shot 2017-05-03 at 8.15.39 PM

Maybe not tomorrow, maybe not this year, but at some point, the chickens will come home to roost and we will have some ugly decisions to make.  At a minimum, our government cannot add $1.4 Trillion to the debt each year – don’t believe those news items saying that the deficit is shrinking like we have heard for a couple of decades.  If our spending only $400 billion deficit per year as we heard in 2016, there is no way we could have put on $1.4 Trillion in new debt.  The government has lots of ways to obscure what they do at both the state and national level, always follow the money and you will see what is really happening.

With the stock market surprisingly holding onto its gains in spite of the fact that:  (1) economic indicators have turned down, and (2) the Federal Reserve stated today that they were on pace to raise interest rates again in June, we will continue to hold onto above average levels of cash so that we have funds to invest when we finally get the over due correction.

The stock market months ago separated from the economic reality of our country – that cannot continue and the smart money is holding on the sidelines to buy when values are more compelling.  I know it is hard to sit back and see the market at current levels, but its better to give up a couple of points of upside in favors of double digit upside in the not too distant future.

In spite of the above statement, as companies in my favorite investment themes have a pull back in price, we are buying or adding to positions.  Those themes are:  cloud computing, selfies, experiences, home life, and pets to name a few.  These are all things that are in secular upswings (businesses moving operations into the cloud; people wanting to look their best knowing that there will photos of themselves on facebook or instagram; the current trend of people not spending money on stuff but spending it on events or vacations that they can experience with families and friends; the trend toward staying home and ordering pizza, watching movies, and playing video games; and the fact that people will spend money on their pets through good times and bad, particularly since the pets are part of the family and add to the home life trend).

For those of you who grew up in the 60’s and 70’s, this is for you…

For those of you who want something a bit more recent (ok, its still from the 90’s) this is for you…


Our Schizophrenic Economy

March 22nd, 2017

00Thanks to Zero Hedge for the above graphic

Double click on any image for a full sized view

 As I do most mornings, I read through various news papers and financial websites to see what is happening in the world, the markets, and our economy.  This morning, I was listening to the business news on CNBC and a guest was talking about our booming economy at the same time as I was examining the chart above that appeared under this caption:  “Industrial Production has never declined on a 24-month basis without the US economy being in recession.

How can two sources reach such diametrically opposed conclusions?

If you look at the stock market, you would think that CNBC is reaching the correct conclusion.  Check out the 5-year graph below of the S&P 500 Index:

00Looking solely at the price graph in the middle, you see a fairly consistent upward trend with only a couple of corrections and the index near an all-time high.  That sort of price action can be intoxicating and draw in investors who have been on the sideline waiting for another of those corrections in order to invest.

However, if you look at a couple of the indicators on the graph, I read those as troublesome for the market.

First, you see the two pink dashed lines that bracket the price graph in the middle.  Those two dashed lines represent a level of 10% above and below the 200-day moving average.  In previous posts here on the blog, I’ve written that these two levels are strategically important as the index historically has oscillated between levels that are either 10% above the index’s 200-day moving average or 10% below the 200-day moving average.

What this means is that from a historical perspective (and obviously there is no guarantee that the market will act in the same fashion as it has in the past), a safe time to buy stocks is when the market hits the line that is 10% below the 200-day moving average and important time to sell is when the market hits the line that is 10% above the 200-day moving average.

If you look closely, the market touched the 10% above line a few days ago and has been weak ever sense.  If you look back to the two corrections in August 2015 and January 2016, both of those drove the price down to that lower line, but the market soon recovered to higher prices.

Below is a 20-year view of the index with a weekly instead of daily price graph:00This 20-year view gives you some longer-term perspective.  Even when the market falls apart like it did in 2001-03 with the NASDAQ crash and 2008-09 with the Subprime Debt crash, with the price graph dropping below the lower line, it is still a good indicator that you should consider putting some money into the market and NOT selling at the bottom.

The other indicator that is bothering me is the PMO (price momentum oscillator) at the bottom of the 5-year graph above.  On the far right, you can see that the black indicator line has has fallen below its red signal line.   This is telling us that even though the index has not yet materially fallen, the momentum behind the move that has pushed prices higher has weakened significantly.

Check out the longer term graph below and you can see from a historical perspective the relationship between the two:

00This chart is a monthly view of the index instead of a daily.  You can see that I’ve circled that spots where the PMO changes direction and the market follows suit.  This has been a fairly reliable indicator of when the market is going to change direction.

So which is right?  Are the economic indicators that are flashing warning signs of recession correct or is the stock market that has continued to power higher based upon the hope for tax cuts and simplified regulation correct?

For what its worth, I don’t have the answer – only time will tell which right.  However, what I do know is that the stock market is over-valued by 10% or so and that we are due for it to correct back to the 200-day moving average or maybe more (see the prior blog post for a discussion of my fair value model for the S&P 500 Index to understand the 10% or so over-valued statement).

Prudent investment management dictates that we maintain a conservative posture with regard to our investment activities.  Because of this, we will maintain above average cash and fixed income reserves in order to have liquidity to buy our favored companies when the inevitable pullback occurs.

To The Moon, Alice, To The Moon

March 1st, 2017

MarketClick on any image for a full sized view

Well, we had a huge day in the market today and I thought that it deserved a bit of discussion.  As everyone who reads the blog knows, I am very cautious on the markets right now given their level of extreme excitement, extreme greed, extreme overvaluation, and negligible expected forward returns.

Take a look at the graph above – in the RSI indicator at the top of this S&P 500 Index graph, you can see the huge turquoise area above the top line.  This indicator is telling us that there is extreme excitement and buying interest in the markets and that they are due for either a pullback or a rest with some weeks of sideways movement.

greedCheck out the Fear and Greed Index above – this is one of the highest readings I can remember seeing on this indicator.  Contrary to what you are hearing on tv, market do not go in a straight line like a rocket to the moon.

Fair ValueAbove is a spreadsheet I’ve posted on this blog in the past – it is one I use to gauge where the market is valued compared to its historical valuation levels.  It uses four  different valuation measures and comes up with a weighted average valuation.  Right now, it shows that the market is 13%+ overvalued.

Expected ReturnsThis is another spreadsheet that you have seen in the past here.  It is one that I use to calculate the expected forward returns for the S&P 500 Index over the next decade.  Based upon today’s valuation for the market, we should expect a forward average annual return of 3.86%.

I know it is fun to watch your portfolio value go up when the market is on fire like it is now.  However, it is equally as gut wrenching to watch the value of your portfolio go down when the market takes a major tumble.  That is why it is imperative that investors employ risk management techniques to make sure they keep the gains in their portfolio when the market goes down.

We are employing those risk management techniques, booking gains on certain holdings, keeping cash and short term bonds on hand to protect the portfolio from the inevitable downdraft that will take the valuation down toward or below its fair value.

Our strategy will be one we have used over the decades I’ve been managing money – use that cash and those short term bonds to buy shares of companies we want to own that have superior investment characteristics at liquidation prices from investors that did not manage their risk and are panicking during the inevitable correction.

Warren Buffet has said that “You pay a very high price in the stock market for a cheery consensus.”  And that “the time to buy is when there’s blood in the streets” (I believe he was paraphrasing one of the Rothchilds in the last half).

This is in essence what we are doing – employing the greater fool theory of investing:  we sell appreciated shares of stock to someone and book our gains, then buy it back from them later at a significant discount.

The market does not go in a straight line like a rocket heading to the moon – there will be a day of reckoning  when fear “trumps” greed.  But until then our strategy will be to continue to make money off the investments we have in the market, book profits when the fundamentals so dictate, and manage our risk so that we can take advantage of any corrections and the people who did not manage their risk.


Bonds Are Boring? Hardly

February 3rd, 2017

10 yr

Double click any graph for a larger view

With bond yields on the rise, the investment landscape has change quite a bit.  Last July marked a low spot in bond yields with the 10-year Treasury Note hitting a 1.34% yield.  You can see that low on the chart above and the subsequent steady move higher until the November election.  The move higher in yields after the election was the fastest move in yields that I have ever seen.

At that time, bond investors believed that the new administration would institute pro growth policies that would move the sluggish sub 2% GDP growth we currently have to between and 3% and 4% GDP growth.  That sort of growth is typically inflationary so investors were moving yields higher in anticipation of higher inflation.  However, you can see that since early December, investors have begun to waiver in that belief and yields have come down a bit.  However, now that the Congress is behind tax reform and regulatory reform, growth could very well pick up and yields could embark on another move higher.

If we are in fact moving into a period of sustained moves higher in rates, this could be the end of the 30+ year bond bull market that has taken yields on the 10-year from just shy of 16% to today’s 2.5%.  You can see this move in the graph below.

Screen Shot 2017-02-03 at 2.02.14 PM

The graph above gives you a long-term historic perspective.  But lets focus on the graph below that I have annotated with a red trend line that follows yields as they have fallen over the years:

10 yr bull 30 yr

The thing that bothers me is that yields have broken above the down trend line – IF this means the bull market is over, then from a purely technical perspective we could see a move to 5%.  You can see the blue line I have drawn at the double top in yields on the left side of the blue line.  The double top is a strong technical level that will act as resistance if yields approach 5%.

The real question is, from a fundamental perspective, would the economy support that level of yields?  It really wasn’t that long ago that we had 5% yields – in fact it was just prior to the Great Recession that started in 2009, commensurate with the subprime crisis.  If you were to look at GDP growth at that time, it was in that 3% to 4% range.

This is not a prediction that we are headed to 5% yields, but rather a recognition that it is possible if the new administration’s policies do in fact spur GDP growth (that is no sure thing – lots of variables enter into it).

So, for prudence sake, I want to give you some perspective on what we are doing in the face of rising yields relative to our clients’ portfolios that have an allocation to bonds.

Someone told me long ago that individual bonds are preferable in a rising yield environment.  However, bond mutual funds and closed-end bond funds (bought at a discount to NAV) are preferable in falling yield environments.  Below is some of the logic that we employ when making decisions in managing a bond portfolio.

  • Investors do not understand that they can lose money in bonds – they view them much like CD’s where a dollar in is a dollar out, plus the earned interest.
  • With a bond fund in a rising rate environment, the loss that they see on the principal of their investment can equate to multiple years interest earned, depending upon the credit rating and duration of the bonds in the fund.
  • Providing clients a portfolio of individual bonds, A rated or higher (whether taxable or tax exempt, subject to the needs of said client), allows us to structure a portfolio that has frequent cash flow for reinvestment as yields move higher and as the bonds mature at face value.
  • Even if there is some market value fluctuation, everyone knows that it is temporary, as they see those market values move to par at maturity.  You do not have this with a bond mutual fund where there is no maturity date for the bonds to reach.
  • When building a portfolio for clients, it is imperative to be sure that your positions are fully diversified with no concentrations in companies, industries or sectors.   I’ve seen several investment managers not take the same diversification precautions with individual bond portfolios that they do with equity investments.  In 2008, several managers had a significant overweight in financial industry bonds.  They were lured into them as the banks, brokerages and insurance companies were paying much higher interest rates on their bonds than similar maturity and rated non-financial industry bonds.  Their clients suffered significant and irreparable losses when Bear Stearns and Lehman Brothers collapsed.
  • Mortgage backed amortizing bonds, like GNMA’s, which are great for larger institutional clients because of their constant cash flow, are absolutely not right for individual clients.  The accounting for the principal and the interest is too complex and many individual clients view the entire P & I payment as income that they can spend – not a desirable outcome if they need to reinvest the principal for future income purposes.
  • In a falling rate environment, closed-end bond funds bought at a discount can be extremely profitable.  In the past, we have purchased both taxable and tax exempt closed end bond funds at 8% – 10% discount to NAV, collected the income, and held them until they reached a roughly 5% premium to NAV.  We easily made over double digit returns on this strategy without undue risk (we stick to investment grade corporates, governments, or muni’s).
  • Bond mutual funds also work very well in a falling rate environment.  You can purchase a fund with a long duration that will maximize your capital appreciation as yields fall and you collect the income stream as you wait.
  • If you were to have a portfolio individual bonds of similar duration as the bond funds, investors can be confused by the lengthy maturity date far into the future.  You therefore end up constructing the portfolio with shorter-dated bonds and therefore abdicating the larger capital gains that comprise a large part of long-term strategy in bond portfolio management.

One last thing I wanted to point out is bonds can have a place in an all equity portfolio as well.  There is a strategy that we utilize when a stock market correction runs its course –  we invest in high yield bond mutual funds.   The capital gains you realize from the high yield bonds as the stock market recovers are even larger than those from the stock market itself.  The high yield bonds are a higher beta way to capitalize upon the recovery with a portion of your equity portfolio – but we never allocate more than 5% of an equity portfolio to high yield – it just would not be prudent.  Check out the graph below:


This is a graph  of the S&P 500 Index showing the 2008-2009 stock market crash and recover in red and high yield bonds in blue.  You can see that the high yield strategy provides higher returns during the recovery part of the stock market cycle and then they revert to an equity level return as the recovery runs its course.