A Ticking Time Bond?

By: Bugra Bakan

Q: Why do Economists make predictions to the nearest tenth of a percent? A: To prove they too can have a sense of humor.

This is my fourth calendar year writing newsletters, and second in TABC Blog. Time surely flies If we don’t pay attention to where we are today in relation to our longer term goals, we may find ourselves getting a wake up call rather late in the game. The key question for someone in my position to raise is: do you have a financial plan and how are your current financial circumstances positioned in relation to that big picture? More on this later.

In every bull market regime there are naysayers, who are not convinced. When the market is down, they warn you of a value trap. A value trap is a condition when the price to earnings (P/E) ratio is low, which is usually one of the reasons to actually start investing. Ideally, you’d rather pay less for given earnings and that’s why when prices fall, stock screeners trigger a buy signal to a value strategist. Since it can’t be that simple, what could you be missing? This is where the value trap comes in. Are you getting what you are paying for, a low quality stock? A low P/E may be a warning for deteriorating earnings, which would further push down the price of your investment and that’s when you fall into the trap.

When prices go up, these naysayers will say that the market is overbought, too stretched, due a correction and resembles the last “sucker’s rally.” A sucker’s rally is typically seen just before a peak and a sharp drop after, or will follow lows and attract those who think the bottom is seen only to find out that this was a “dead cat bounce” and there is more room to the downside.

The good news for all those with a never changing and consistent message is that even a broken watch is accurate twice a day. So eventually they will be proven right because at some point, market will start a down trend. Here comes the million dollar question: are you investing to be right or to make money? A rather simple question and you’d think everyone would say “Of course…to make money.” But if you watch carefully, you’ll see that most people would rather be right and in the process of being so, will either lose money or miss opportunities. So here is the best thing you can do before you make any kind of investment decision: Check your ego out the door and aim to make money (and not to be right). Here is what the legendary Jesse Livermore said: “The most expensive way to find out who you are is through investing.”

After all that naysayer bashing, frankly I am not even sure if there are any left around. Professionals would know of the Economic Cycles Research Institute (ECRI). This is (or used to be) one of the most respected economic research houses who has been proven wrong time after time in their calls for a recession. Now finally, even they conclude a recession is a low probability event. The God of naysayers, Nouriel Roubini came out last week saying that aggressive central bank policies (FED’s low interest rate and quantitative easing programs) have and will probably continue to push stock prices up. Thank you Sir. After an increase of 122% in stock prices since March 2009, you jumping on the band wagon actually makes me nervous. Should I switch sides and become a naysayer since you've been grossly mistaken with your calls and now you and I finally agree? If I didn’t check my ego out the door, I would always chose the opposite side of Roubini, but I won’t do that.

In January, the S&P 500 was up +5%, MSCI All Country World Index +4.61%, MSCI Emerging Markets 1.38%, China +4.12%, Barclays US Aggregate Bond Index -0.8%. At this point, there are two very important questions on an investment managers’ desk: 1 – Is this impressive monthly performance setting the stage for a pull back and if so, what to do about it? 2 – Is the bond bull market that started in the 80s coming close to an end and if so, what to do about it? My answers are: yes and yes. “What to do about it” is trickier and harder to answer.

My overall theme is “cyclical bull”  and “risk on” as a result of pent up demand, recovering housing, improving employment, lower energy costs, stabilizing Europe and most importantly, loosening lending standards. The risk to this theme is US and Europe cutting government spending too much too soon (hence the negative GDP result in Q4 2012), debt ceiling debates proving to be problematic, elections in Germany and Italy lowering risk appetite, French real estate bubble bursting and an elevated conflict in the Middle East.

Within the risk on theme, I think there is a bit of excessive investor optimism, which shouldn't be confused with consumer sentiment, which is currently low. Stock market tends to like surprising investors and so extreme investor optimism is usually followed by a pullback. How severe? Because it would fall within the cyclical bull and risk on market regime, I’d have to guess in single digits. As long as this comes with low volume, tamed volatility and narrow breadth, I would consider it as expected.

The bigger question is the future of the bond market. I wrote about this in my last newsletter as well. It is more important because a longer term change is upon us versus a shorter term pull back in the stock market, AND it will impact those “conservative” investors, retirees and pension funds. The consistently falling interest rates since the early 1980s have been pushing bond prices higher and there isn’t much more room left to go. During most of the 2000s, bonds have outperformed stocks. It is easy to conclude this because it is apparent on longer term charts. What is not easy to do is to time the exit. As the saying goes, you can be right on your security selection or with your timing, never both (unless you’re lucky of course). So even if you think the bond bull market will end soon, when do you start getting out? I know my regular readers have heard me talking about this many times in the past but it is eye opening to know that Bill Gross, the Bond King who runs the largest bond fund in the world at PIMCO sold and got out of bonds late 2010. Bonds appreciated in double digits in 2011! So what do you do? I wish I had an easy answer but unfortunately there is none. You have to stay on your toes, that usually helps.

Two trends make this situation rather less alarming: 1 – The biggest purchasers of bonds are the whales in the investment pool like governments, pension funds and insurance companies. These folks don’t wake up one morning and decide to sell their bonds and even if they do, their actions are slow. 2 – The interest rates are tied to inflation and unemployment rate, and neither is giving signs of a quick and aggressive rate increase. My regular readers will remember: bond prices move the opposite direction with rates. A rising interest rate environment will push bond prices down.

If you think about the reasons for bond price fluctuations, you have supply-demand relationship in one hand and interest rate movements on the other, both of which I have addressed in the above paragraph. Inflation is a direct result of money supply and interest rates are reactionary to inflation, not the other way around. I have discussed inflation in great length in one of my previous newsletters, but maybe it’s time to revisit and talk about it again and refresh our memories. That will be next month’s topic.

So the ticking time bomb may not explode overnight, which is good news but could also be bad. Oh come on, how can it be bad, it will give you the time needed to get out right? Yes, but have you heard of the story of the frog boiled to death? Not a pleasant story for sure but very telling on social phenomenon explaining human behavior in masses. It is told that if you throw a frog in boiling water, it will jump out and save itself. However if you drop a frog in cold water and slowly increase the temperature, it will acclimate and boil to death. Luckily I have never tested this personally and am not even sure it’s true for all frogs. I am going to guess that there are some smart frogs out there who have heard about their cousins dying in the kitchens of a bunch of 14 year old boys and they are prepared to jump once they feel the water is getting warmer. But the moral of the story is still worth paying attention to: if you allow yourself to get comfortable with smaller losses, 0.3% today, 0.2% next day, you may find yourself looking at a much larger loss within a few quarters. How do you reconcile a need to keep a longer term view and not give knee jerk reactions with the need to protect your portfolios from losses? Not easily.

Planning for 2013

This time of the year, I get calls from friends asking about how to plan for the previous year. As you will agree, planning is a forward looking process and retroactive planning won’t be effective. So here are some commonly known, easy to do things for 2013.

Budgeting: One of the newer terms that is being circulated around is, life planning. I guess financial planning sounds boring and complicated and life planning is more inviting and friendly. I say, whatever floats your boat, I don’t necessarily care what you call it but I do care that you do have one and it all starts with a budget. Without a budget, you can’t really know how much you can save, without a savings figure you can’t know if you can comfortably reach your goals. So, please do a budget. Email me and I will send you a cheat sheet if it helps. If you fail to plan, you’re planning to fail.

Status check on your goals: If you’re one of the few out there with a plan, check status and see where you stand against your goals.

Max your 401(k)s or IRAs: If your cash flow allows, and you’d know this if you had a budget, max your IRA contributions for last year and this, or your 401(k) for this year.

Do Roth Conversions if Appropriate: If you’re laid off or for other reasons dropped your tax rate, do the math and convert some of your IRA dollars to Roth IRA. The amount that is converted will be added to your income, so this has to make sense and carefully calculated but the years that you were laid off or stopped working can create opportunities for doing things otherwise tax costly.

Decide on your cost basis strategy: Check with your brokerage account settings and see what method is being used for recording cost basis, ex: LIFO, FIFO. This can save you some tax dollars if planned well. For instance, if you buy a stock at $30 and $35, and decide to sell for $40. If your set up is FIFO (first in first out) you will pay taxes on $40-$30=$10. If your setting is LIFO (last in first out) you will pay taxes on $40-$35=$5. You can change this setting any time, for any account.

Check your overall asset allocation: Are you properly diversified? This is by far the most important question after making sure you've checked your ego out the door. Studies show that over 80% of a portfolio’s performance depends on the choice of asset allocation, NOT security selection and yet everybody talks about this stock, that stock without answering should you be in stocks to begin with. Make sure you look at all your accounts and determine that your allocation is a fit to your longer term goals.

Check your investment performance for 2012: I am a fan of annual reviews as I find them very telling. See how your investments have performed last year and check if you’re on track with your goals. If you’re self-directed, revisit your strategy, if you’re working with an advisor, ask to see if you’re still on the same page.

Hope you have enjoyed reading my Newsletter. Next month we will revisit and discuss inflation in great detail. Please feel free to forward this email to your friends and family and don’t forget to email your questions or comments to:bbakan@shieldwm.com


The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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