Tag Archives: Investments

Quarterly Update – 1Q19

The market peaked in early October, 2018, and came very close to the official 20% decline that defines an official “bear market.” The real issue is not the depth of the decline, but how long it takes to recover. After the market roared back (+13.06%) in the first quarter, we are nearly there.

Last quarter I shared a chart I use, that indicated the market was valued at 88% of fair value. Today, that reading is about 98%. There is a natural regression to fair value. We’re about where we are supposed to be, not cheap but not too expensive.

There has been a lot of talk in the media about the “yield curve” and what that means about recession risk. I wrote a blog post on the issue the day the curve inverted on March 22. Link here: https://www.daltonfin.com/2019/03/22/what-volatility-looks-like/.  Sure enough, the inversion was transient, with the 3-month T-Bill currently at 2.4% and the 10-year Treasury Note at 2.41%, virtually flat.

(Caution –  the next 2 paragraphs are on the wonky side)

The spread between the 10 and 2-Year Treasury is Worth Watching. When it goes negative, it is inverted.

The main problem with conventional yield curve analysis is that current conditions are a lot different from past circumstances, after 10 years of central bank intervention. The absolute level of interest rates has not been this low in any prior inversion analysis. To illustrate why this is important, consider an economy with no inflation. If the interest rate is the price of money, how much would you need to be paid to lend your money to the U.S. Federal Government? Now, add that rate to the expected inflation rate to get the level that the 3-month T-Bill should yield today in a normalized environment. Anything short of that is like a morphine drip to the economy. The Fed is trying to wean us, but that requires balancing the market’s tantrums (see December) which can become a self-fulfilling prophecy if a stock market decline causes a slow-down.

The Fed only controls the short end of the curve. The market controls the long end. When bond traders bet the Fed will cut rates, they buy the long end because interest rate changes compound and prices move inversely to rates. Increased demand on the long end causes long rates to fall. The greater concern is when the Fed starts cutting short rates. That signals trouble because they have more information than anyone else. What does the Fed do when they see trouble? They cut short rates to juice the economy. The problem is, there’s usually trouble on the horizon when that happens. The good news? That’s not the case today.

Volatility is the price of equity returns. We can manage risk if we understand your liquidity requirements. If we can anticipate distributions, we can reduce or eliminate the possibility of being forced to sell when the market is cheap. That’s what converts a temporary loss of capital a permanent loss.

What Volatility Looks Like

It is hard to fathom the sway in sentiment from yesterday to today. Yesterday markets soared despite Biogen’s dismal news about a failed clinical trial that caused it to drop about 29%. Markets closed up strongly (S&P 500 +1.09%). Market analysts attributed the broad market strength to investors getting more comfortable with the Fed’s dovish stance.

Today, alarm bells went off because the yield curve inverted. This shouldn’t surprise anyone. The curve has been flattening for a while. The gap between the 3-month and 10-years yields is viewed as a leading indicator. It will be important to see if the inversion persists. The indicator’s success rate as a recession predictor increases when the inversion lasts more than 10 days. This is day 1. That was enough to send the S&P 500 back down -1.9%.

At the end of the day, there is no material, fundamental change. Sentiment changed, and that creates volatility.

Investing involves risk, including possible loss of principal. Past performance is not a guarantee of future returns.

Evidence of Growth

As of mid-year, my single variable economic indicator is still going strong. According to the American Association of Railroads, “North American rail volume for the week ending July 14, 2018, on 12 reporting U.S., Canadian and Mexican railroads totaled 374,909 carloads, up 4.6 percent compared with the same week last year, and 374,090 intermodal units, up 4.7 percent compared with last year. Total combined weekly rail traffic in North America was 748,999 carloads and intermodal units, up 4.7 percent. North American rail volume for the first 28 weeks of 2018 was 20,148,123 carloads and intermodal units, up 3.5 percent compared with 2017.” America is on the move. Will tariffs crash the party?

Managing Volatility in Growth Portfolios

In normal times you might own bonds for either of two reasons.  You might enjoy the regular income from interest payments, or you might own them for the stability they add to an equity portfolio.

Neither of those reasons carry the usual appeal with today’s ultra-low interest rates.  If you’re counting on bonds for income, you are going to need to own a lot more bonds.  While bonds add stability, the total return will be reduced when interest rates eventually move to higher, normal levels.  Neither reason is particularly compelling these days, although the stability factor is more compelling given stability in a quick equity correction.

The bond market is not uniform.  Some parts of the bond market have less exposure to interest rate risk.  Additionally, the proliferation of alternative strategies offers investors a wide array of tools for managing risk in today’s macro driven investment climate.

Much has been written about various types of risk, and that is not the focus of this essay.  My purpose is to explain an approach to managing equity market risk in the current low-interest rate environment.

Liquidity is important.  Let’s take the case of the Brexit induced market decline that began last Friday.  Over two days the Dow lost about 900 points as stunned markets went into “sell first, ask questions later” mode.  If you believed, as I did, that the world economy was not poised for mass suicide, and that cooler heads would prevail as hysteria faded, you might have been inclined to sell some of those bond positions to buy equities at distressed prices.

If those bond or alternative positions were in mutual funds, the cash would not be available for trading until the next day.  Using margin is not a bad strategy, since you can execute a purchase locking the price before the bond fund sale is complete.  If you wait until the next day, the price could be higher.  It could have gone lower too, but that’s speculation.  If you want to control the trade, you want to make timely buy and sell decisions.

Using hedge positions in ETF format eliminates the liquidity problem.  Unfortunately, many of the better bond funds and hedge strategies are based on active management, and hence not available in ETF format.  There is no perfect solution.  If the main objective is performance relative to a benchmark, for a fixed/alternative portfolio component, then the mutual fund liquidity problem can be overcome with judicious use of margin.  If the objective is to hedge a richly valued market in a world fraught with macro risk, then bond sector ETF’s can fit the bill.

Then again, in a rich market, cash is an attractive asset class.  To paraphrase Charlie Munger, a good way to get rich is to put $5 million in a checking account and wait for a good crisis.