I am watching the relationship between TLT and SPY.  Friday (and today's) movement in TLT versus the SPY are perhaps an indication that an inverse relationship between these two asset classes is returning.

If that's the case. then TLT would return to being able to diversify a portfolio.

One conclusion we can draw from the news and market reaction to it is that stocks are showing some interest rate sensitivity at this level.  It is more than I thought, but the market is king.  What can we learn from it?

If we review previous market activity, we saw clear negative bond reaction to the specter of higher rates but we did not see much of a negative response from stocks.  One explanation is because the market expected the Fed knew something about prospective growth that was on the way.

Now that we have a move lower in yields, stocks have reacted positively.  So, maybe stocks do have more room to go up if rates go down further (which I expect), but what about the converse- will the market be as sure that if the Fed stops accommodating it will be because they see growth?  Or has the Fed lost some credibility?  

Is there some asymmetry that we as investors can take advantage of?  For my own part, I have been too ready to worry about top line growth.  The market is not there yet.  It is not a focus.  I have written in the past about the change in focus from time to time.  Right now it's all about the Fed decision.  As such I should have seen that if I was right about the non tapering, stocks would see lower rates and move positively.  If I was wrong, bonds would continue to slide down in price and stocks would not care.  The "caring"/focus may come after once the Fed path decision is out of the way.  So for me, it should have been stay long stocks and keep/add to my bonds.  Instead, I started worrying about the top line growth a bit too soon and cut my equity exposure which has cost me about 1% so far.  Not fun.

So where from here?  It's still about the Fed.  The focus will shift to data and whether the Fed will read that positively.  So maybe now the top line discussion will start again.  

For my money, we are still in a very slow growth economy and the risk is for a further slow down if rates stay up.  So, I believe it is logical for me to stay low in stock exposure and maintain my bonds (if not increase).  But herein lies a management issue.  I usually try to set up my portfolio in a hedged manner.  I want to have bets that payoff when I am right, but also some that pay off if I am wrong.

If I am wrong and there is a spark somewhere, stocks will go up and bonds will go down.  My portfolio will get hurt both ways.

Spread products can help here.  Things like loans (VTA, VVR), muni (MHN, MUB), preferreds (PFF, JPS, JTP) I believe will do well in both scenarios.  My bet in those is sizeable around 50-60% of my portfolio.

If I were to properly construct my portfolio (make it more efficient as in lowest risk for a given return expectation), then I should not have same-way bets on in both my bonds and stocks.

In order to achieve that, I will shorten my duration while maintaining the credit position.  I can do this by selling my TLT.  The downside to this strategy is that if there is a global risk off event, I won't have a position that makes money.  I won't lose too much though as my stock exposure is minimal.

Surprise!  Not.

This episode reveals a little appreciated fact about investing.  You can be right and lose money (as I have).  I did not believe it made any sense to let off the easing pedal (at least if you believe what the Fed said they were looking at).  And so, it came to pass.  At least for now.

The end of the fed accommodations is approaching, but for now they are holding the line.  Which brings me to y other point which is the lack of top line growth.  I do not believe stocks should go up merely because rates are staying low.  That does not make sense either.  I think that rates have been low for long enough that the "refi" at the corporate level is basically done.  Earnings will not improve much from lower financing rates.

So earnings at this point have to come from productivity or top line growth.  Productivity is tough when companies are not making significant capital expenditures (which they haven't because they have been squeezing margins to get every last dollar out).  So it needs to come from top line and I just  don't see it yet.

Thus, I am taking my equity exposure down significantly - to about 10%.  I could still benefit from a rising stock market as spreads improve on the ETF's that were pummeled, but we shall see.

T
ATT has seen a big retreat of over 10% from it's highs.  It trades at a great multiple and has an excellent yield of over 5%.  I like the telecoms a lot.  I hold VZ as well.  For my money, wireless is the only way forward and these companies are positioned to benefit from expansion in the wireless world.

I have bought some this morning in the low 33's.

JTP
I also am buying some more preferreds through JTP.  I like this play.  The fund trades at a sizeable discount of 12% and yields around 8%.  I don't know if the market will love these again, but at least it pays a good yield and I think that yield is safe.

Another poor number on the employment front.  In addition, June was revised down by almost 50%!!

So, for today, bonds have seen a reprieve from the selling.

While I am feeling ok about my bet on bonds, both maturity and credit, I am less confident on stocks (not sleeping well if truth be told).
My exposure is high around 55% and I am trying to justify it.  Walking through the rationale with this blog helps me clarify my thoughts so, I will attempt to do so.

Estimated earnings on S&P 500 is about $110 as far as I can tell.  This is a moving target, but I think it's close.  With the index at 1660, that puts the forward PE ratio at about 15.1 and the earnings yield E/P at 6.62%.  With 10 year treasuries at a bit less than 3%, that leaves the risk premium for stocks around 3.7%.  Historically, this is still a good signal for owning stocks (anything north of 3% has rarely resulted in negative returns for stocks.

However, we are not in super cheap territory and any surprises in the inputs and stocks don't look as attractive.  For example, if bonds yields creep up to the 3.5 area (would not surprise me in the short term) or earnings start to falter.  This latter possibility is the one that has me worried.  While I feel that companies will do well enough to pay their debts, I am not so sure the market will be happy with earnings growth prospects.  We have not seen any top line growth to speak of and ultimately, the market will focus in this and revise the multiple they are willing to pay for stocks.  We could see a return to stock premiums of 4.5% which would imply a PE of 13 and an index level of 1430!

Presumably, there is a counter-case - earnings continue upward, we get a surprise in top line growth, rates go lower.  All of these are possible in which case, we could get a move up, but it is difficult to see any more PE expansion.  Maybe 16 is possible, but I would be surprised.  I don't think you get a big move into stocks if bonds keep falling in price because overall the economy is leveraged and rates do matter to earnings.  I would rather feel strongly about growth from top line rather than squeezing pennies from costs.  But, that does not seem to be the most likely outcome.  Perhaps the biggest  upward pressure is from funds being underinvested, but with our fiscal picture unclear (and more war possibilities) I think the macro picture is murky enough to hold funds from making large allocations to equities.

So currently I am seeing limited upside for stocks and some serious potential downside.  I don't normally make short term timing bets, but I am considering doing so and using some technical indicator (like our previous high- 1703.50ish) as a stop loss level.  Or, using the 16 multiple which would take me to 1760.  The trouble from the technical side is that I see support around the 1636 level and we are closer to that, so from a risk reward perspective, it makes sense to wait to see a break of that before acting.  Disclaimer:  I AM NOT A TECHNICIAN, so anything I do on that front is probably mularkey!

The most sensible approach is to moderate my exposure back to benchmark levels around 45%, or maybe a touch lower then maybe I can get some shut-eye.

I've updated performance for August (and July somehow it didn't save previously)

Overall stock exposure is high for me at around 55%.  That said, my portfolio is underperforming as I don't seem to have the "right" 55%.  Part of the problem is that I classify PFF, JTP and JPS as equity and they have behaved more like interest rate sensitive stocks.  I don't disagree with that assessment as preferreds have limited upside.  Back when I first purchased PFF, this was not the case as the preferreds were trading at such a huge discount that they acted like stocks during the rally.  They are now more fully priced, so from here it will behave more like fixed income.  I definitely should have been more dynamic in reclassifying the ETF's in my portfolio.

If I reclassify, my weight in stocks is around 40% and about 60% in bonds.  This would be more in line with my performance versus the benchmark.

In the past, I have not been as concerned with lower returns, as my Sharpe ratio was staying at a comfortably high level.  I have recently dropped below 1.0, which I am not happy with.  The interpretation is that my portfolio is too risky for the return I am getting.  The benchmark is still well above and I should take steps to look more like the benchmark.

Aside from some poor stock selection (AAPL, RAX and few other) the major source of my underperformance is longer duration.   I have had my bond exposure too long versus the benchmark of 10 year treasuries.  I am still convinced that long maturity bonds  are a good buy.  I am not convinced by growth in the US (or globally for that matter).  QE taper, or not, our rates should not be going up.  In addition, my muni bet has been a killer.

I do expect the muni ETF to come back over time (with the help of dividends, of course) but it may take a while.  I should add some more on down days.  If I do, it will be on a duration hedged basis.




KMI
has suffered a close to 10% drop, perhaps on some news that an analyst is going to show that company has some irregularities.

I am going to take this opportunity to buy a bit more of this stock.

CLX and KMB
are trading at relatively high multiples.  I previously trimmed  (or completely got out) of some of my big cap dividend stocks (KO, PG, GE, JNJ) and while that proved to be a good move, I did not sell any CLX and KMB, even though they were just as highly valued.  I chose not to at the time because I reasoned that their higher dividend payouts would shield them a bit more from downside.  I am not so optimistic right now so I am looking to trim those positions and maybe get out.  Taxes can sometimes be a hindrance to moving positions around, but I try my best to not let them intrude too much.
JNJ and GE are now close to buy levels again.

I will look to replace the equity exposure with SPY or IWM.