Friday, August 30, 2013

A good (if expected) revision for second quarter GDP growth to 2.5% vs 1.7.  This is a massive change and instinctively makes me think of rigged games.  But, let's take it at face value and think pro-actively.

With a growth rate of 2.5% and inflation at 1.5-2, that argues for long term rates in the 4-4.5% range. Our 30 year is there at the low end.  If we consider that the market expects inflation over the long term, to be around 2.4, then we may extend as high as 5%.

This brings to mind an important distinction to make between bonds and bond funds.  Bond funds (and ETF's) are generally managed to certain characteristics (i.e. TLT long maturity 20+ year US Govt Bonds).  Their holdings do not "roll down".  In other words, the duration/maturity remain somewhat constant.  As such, they are riskier than individual bonds which "roll down" in maturity and, assuming the issuer does not default, pay back the lender.

In Bill Gross's last Insight piece,

he goes through a rather roundabout way of describing different ways to earn bond premium.  What I think is the most important conclusion is that there are multiple ways to earn spread on bonds.  When rates are very low, the maturity premium (extending maturity) is not a great option.  I understand this conclusion but in this last move, it wasn't just maturity that got hammered, it was everything else too - credit, volatility, whatever - if it's was bond related,  it was sold aggressively.

This somewhat indiscriminate selling has left us with some opportunities - in preferreds, munis, loans, corporate bonds, high yield.  And with maturity as well.  I think the curve is a bit steep and the long end represents good "relative" value.  This is a a tricky term, you can be correct making a relative value trade and still lose if you didn't hedge out all of the other risks properly, so I would leave the relative value trades to full time portfolio managers.

I am losing a bit of my zeal for the low interest rate environment not so much from the standpoint of the long end, but eventually, we will be in a situation where the short end is going to become suspect and if that transition doesn't go smoothly (what does?) then we will have a fair amount of volatility to contend with.  Right now, I think finding places to earn spread when there are discounts to NAV in ETF's, is a good place to start because there is an extra bit of cushion if rates do go up further.

Monday, August 26, 2013

Today I am selling some of my AAPL position.  It has been a large weight -5.5% and while it is still cheap, I don't think it as special any more.  I will reduce it closer to 3% position which will be similar to my other single stocks.  I will look to replace it with SPY or IWM.

Friday, August 23, 2013

This is a chart of TLT, the long dated US government bond ETF.  Through most of 2013, the Fed has been buying 85 billion / month.  Previously, in 2012 it was buying 40-45.

A lot has been made of the effect of the bond buying, but I honestly don't see it.  Bonds did not rally substantively in that period.  One can argue then that if they stop buying, then bonds will drop, and that may be as a big buyer will leave the market.  But, tapering does not mean they will sell either.

I would argue that the long term treasury, while affected by supply demand, is more a reflection of growth prospects.  A global one at that.  What are our prospects now versus earlier.  Inflation is no higher, so I would not sell bonds on that basis.

I think the selling is overdone and project a rally in the TLT back to the 110-115 levels.

Thursday, August 22, 2013

I had a good discussion with a friend about the "normal" level of interest rates. I know you are thinking, "What scintillating discussions!", but please contain your excitement ;).  

Above is a graph of "EXPECTED" real interest rates from 1960-2012.  I'll put quotes around expected because I am doing a quick and dirty analysis and not being particularly careful.  For those that care about the details I did use, I used an average 10 year rate for the year (so this assumes the market is basically efficient) and I used the inflation rate for the previous year (so the market has some memory here).  Ideally I would use the expected inflation rate, but I do not have access to that info immediately.

I do think the basic idea will come across though.

I wanted to have an idea of how much market's expectation changed over time.  The answer is quite a lot.  In the last 50 years, we have ranged from -2.5 - to +9.4.  There have been a lot of different effects here - high and low tax regimes, inflation, (almost deflation), productivity changes, busts and booms.

On average the real return is around 2.6%.  I have been saying I would buy TIPS if the real return reached 2%, perhaps I am a bit low on my goal.  Another conclusion is that we are not in any particularly new world contrary to many pundits.

This graph shows S&P returns versus CHANGES in expected returns.  We see the proper expected trend, a decrease in expected real interest rates coincides with generally positive S&P returns.  I think there is a causal relationship here.  It can be a bit of a puzzle to see large positive real interest rate changes and positive S&P returns, but we can view this as a positive sign because I think that is where we will find ourselves this year.  Real return expectations are being ratcheted up and stocks are remaining buoyant.

As I alluded to in a previous note, it appears we are having a change in overall expectations.  Over the last few years, we have seen a downward trend in real expected returns and that may be changing.  If so, then S&P returns should see a head wind that will keep returns from exploding upwards.  Stocks should be ok so long as inflation does not get away from the Fed.  Bonds of course will face the stiffest challenge.  Bonds will suffer on a re-valuation of real interest rates.

So a re0valuation may be healthy over the long term back to "normal" levels around 2.5% and stocks can handle this while bonds will suffer.

HOWEVER, and this is a big "but" for me, the question is will the Fed "allow  a revaluation?  I am in the camp that speculates that the Fed will NOT and so will continue to keep supporting the market.  

In either scenario, spread product (corporate bonds, loans, high yield, muni) will be a good investment because they have gotten wacked (technical term) and are trading at high spreads versus treasuries.  Stocks are ok as well and I like the preferreds especially because they are safer and carry a nice yield.

I may be wrong about the Fed in which case, bonds will continue to sell off (at least government bonds).  So my conclusion is that I should eliminate my government bond exposure (TLT) and replace with either stocks or my spread product ETF's.  The only reason to hold off would be that TLT in theory would protect me if there is a crisis of some sort, which of course is difficult to predict.  Currently my weight in TLT is about 6.5%.  I may leave it there and instead look to add to my other bond positions or add to equity. 

Friday, August 16, 2013

The blue line represents MHN over the last 3 years, while the white line is MUB ( a national muni bond fund with no leverage).  The purple line is TLT (governent long term bonds)

Since end of April, the returns have been MHN -20%, MUB  -8% and TLT  -16%  Pretty scary stuff from MHN (and TLT).   If we go back to the beginning of the year, we see even worse form MHN (an additional 10% decline).  Some portion of this is due to the erasure of the premium to NAV that existed and now it is at a 6% discount.

While I do not make any major trimming of my holdings in this ETF, I did reduce when the premiums were over 5%.  That said, I have been buying as the discounts became bigger.

This is a core holding of mine and needless to say, this has been a big negative on my returns.  The questions is (as always) what now going forward.

Probably the biggest negative is the potential for a payout cut.  The latest earnings were .0722 and the payout is .0765 so that is a cause for concern, but I do not believe that will happen yet.  The market may be pricing in a cut, however.  MHN is also suffering from duration and it's exposure to long term rates.  Historically though, muni's have traded at lower rates than treasury bonds because of their tax treatment.  Perhaps the market is pricing in that the tax favored status of muni bonds will be eliminated or reduced somehow.  This is a possibility, but I do not place a high probability on it because I feel that states would suffer tremendously in their ability to access the bond market.

MHN is suffering from a lack of buyers.  It is not an ETF with high volumes, so it can be "manipulated" in an outsize manner by one or two large orders.  I think this is happening as well.  There is no real urgency to buy right now as the market is in a general upswing in bond yields.  Buyers are waiting and sellers are trimming.

For my own part, I am not selling as I feel that earning a 7%+ tax free yield is VERY attractive and I do not feel that NY is in particular trouble.  I am considering buying even more, but I am already around a15% holding in my portfolio, so I don't have much to go on this one - maybe 2-3%.

Where I have bought a bit is in the preferred sector.  PFF is yielding 5.1% and I think this is an excellent buy.  JPS and JTP are lower volume (so higher trading costs), but they are yielding over 7% AND are trading at HUGE discounts to NAV. (over 10%).  

I am looking at this one again as it has dropped about 20%.  Their payout ratio is looking a bit high so I am worried, but they have been solid at managing in the past.  I am willing to give them the benefit of the doubt and thinking of buying more.

Thursday, August 15, 2013

Ugly day in the financial markets.  Everything is being marked down.  "Not a good sign when both bonds and stocks are going down", my old mentor would say.  Simply put, today is a day when the markets are reassessing the price of financial assets and pricing them such that the forward (expected) return is higher.

This can continue for a little while, but I do not believe there is much behind it as there is still a lot of liquidity in the market and no sign of it going away any time soon.

Long dated TIPS are getting close...  1.45% real yield or so.  At 2, I move a good amount in.  Even here I am thinking of swapping some of my TLT for the actual TIPS bonds.

Updating my favorite metric, with current forward PE of about 15 on the S&P and 10 year bond yields around 2.77 the spread of stocks over bonds is about 3.8% which is as low as it's been in a while, but it's STILL an attractive place to be long stocks.

Only 2 out of 13 years where the premium has been over 2% have resulted in negative stock returns (1966 and 1974).  I like the odds and I will be looking for ways to increase equity exposure.  JNJ is down almost 4% from where I sold it a few days ago.  That's probably a good discount on a great stock.  AAPL has bounced nicely, but it's still cheap and I think ultimately it will pay off from these levels.  I keep thinking JCP is a good buy, but it is very risky, although it probably doesn't have much more downside than in the 12's.

Friday, August 2, 2013

Employment numbers were weak.  Not just the headline number for the current period, but also the revisions for previous periods.

I have trimmed some positions that I did not have high conviction:  RAX, NUAN, CLF, KO and PG.  The last two may come as a surprise.  I still like the stocks, but I think pricing is a bit high (dividend yield a bit low) and I would rather hold the index instead of the individual stocks.  It is a bit simpler.

Simple is good.

TIPS have started to get interesting here at least in the long end.  The 30 year is now trading at a 1.38% real yield.  For me, 2% is a magic number and I would purchase them again at that level.

Thursday, August 1, 2013

Performance is posted.  Nothing to write home about.  I've lagged with my exposure to long bonds as well as closed end funds that have been hammered to sizeable discounts.

I still like the funds, ut clearly they are being punished by a market that has flipped a hidden switch if you will.  TLT and other bonds are responding only to news about the economy and the eventual end of QE.  Even though I believe the market is not realizing that growth is still anemic and that bonds offer good value, I have been wrong and my portfolio has suffered for it.

In hindsight, I probably should have stayed with the "spread trade" (long credit exposure like muni's and preferreds and loans) and been hedged for the interest rate exposure (selling the 10 year government  bonds).  This would have mitigated some of my losses in the outright bonds that I hold (TLT, MHN, the loans and PFF).

But, I consistently under-appreciate the fickle nature of the market.  The current world is much more news sensitive (everyone sees everything, immediately!) and turns occur much more rapidly.  I have to adjust for that.

Stocks still look good to me and intererstingly enough, I think the rotation has been out of bonds and into cash more than stocks.  I still believe the market to be under-exposed to stocks and that will provide a base for stocks.  If I am right, pullbacks will be shallow and infrequent.  I would not be surprised to see another 10% rally through year end.  Perhaps there will be some pullbacks to buy but I am not going to be too cute about timing.

Today, I am selling off positions that have gotten a bit rich in price or low in dividend yield.  I have sold KO and PG and am considering selling JNJ and GE.  I will replace these with IWM (small stocks) as I think they will benefit from further gains.  Be aware though, that this adds a lot of risk.  Valuations in small stocks are a bit more stretched than SPY.