July 26, 2014 A Moment Like This

Risk/Reward Vol. 229

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“I say we can dance/We can dance
Everything’s out of control
Oh, it’s a safety dance
Ah yes, it’s a safety dance.”---lyrics from “The Safety Dance” sung by Men Without Hats

“I wanna be high, so high
I wanna be free to know
The things I do are right”---lyrics from “Easy” sung by The Commodores

“I can’t believe it’s happening to me
Some people wait a lifetime
For a moment like this.”---lyrics from “A Moment Like This” sung by Kelly Clarkson

By the time our flight from Seattle landed last Friday afternoon, I had completed the first draft of what was to be last week’s Risk/Reward. It was one day after the downing of the Malaysian Airliner, an event that predictably had caused the markets to do a “Safety Dance.” The Dow Jones Industrial Average had fallen 162 points on Thursday (the day the airliner was shot down), and the yield on the 10 Year Treasury had fallen from 2.54 to 2.47. My theme was how investors react when they perceive that “Everything’s out of control”; to wit, they sell equities and buy Treasuries. You can imagine my surprise when I checked my iPhone as we taxied to the gate and learned that the markets had recovered most of the previous day’s losses and that the 10 Year yield had stabilized---this despite no resolution of the Ukraine situation and a worsening of matters in Israel. How could this be? What happened to the ‘safety dance/yes, the safety dance?” I deleted the draft and began to ponder.

And ponder I continue to do. Another week has passed and if anything, the situations are worse in both hot spots. Yet, apparently on the strength of so-so domestic economic news and less than sterling earnings reports, the US stock markets just “wanna be high, so high.” They reach for new records virtually every day except yesterday of course. Meanwhile, the yield on the 10Year holds steady around 2.5%. Each financial news story that I read or report that I hear features someone warning of a coming stock market correction and/or a collapse of the bond market. But, Mr. Market seemingly just doesn’t care. And lest we forget, Mr. Market is the only one who matters. He is “free to know/The things he does are right”---each time and all of the time.

So what does a rational investor do? No economic or financial data justifies the stock market’s unceasing march upward or the year to date performance of the securities priced in relation to bonds (the kind I favor). That said, I am up nearly 10% year to date. Literally, “I can’t believe it’s happening to me.” Until yesterday, it’s been another day, another gain; a situation for which “Some people wait a lifetime.” And yet I am exceedingly uncomfortable. Was Friday's triple digit loss on the Dow an ephemeral reaction to disappointing news from Amazon and VISA or is it a harbinger of things to come? My rational self tells me to sell and to head to the sidelines with my outsized profits in tact (remember I only seek an annual return of 6%). But my competitive self is caught in the euphoria of the day and urges me to stay. Why liquidate at “A Moment Like This”?

In sum, I am living a Kelly Clarkson greatest hits album. One side tells me to “Just Walk Away.” Another side asks “Don’t You Wanna Stay Here a Little While?” A moderate drop wouldn’t kill me and I know “What Doesn’t Kill You Makes You Stronger.” But if I were unable to recover from such a drop by year’s end, “My Life Would Suck.” I solicit input from you, my Loyal Readers. That way, whatever course I choose, I can say it was “Because of You.” In the meantime, I ponder on.

July 12, 2014 Woman To Blame

Risk/Reward Vol. 228

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“Come Monday
It'll be alright
Come Monday
I'll be holding you tight”---lyrics from “Come Monday” sung by Jimmy Buffett

“Portuguese love
Won’t you say it to me
Say it to me
You love me baby.”---lyrics from “Portuguese Love” sung by Teena Marie

“No need to be complacent
There’s chaos across the border
And one day it could happen to us.”---lyrics from “Blood on the World’s Hands” sung by
Iron Maiden

When last I wrote, I was giving consideration to paring my holdings this week in interest rate sensitive securities due to a spike in the yield on (and concomitantly a drop in the price of) the US 10 Year Treasury Bond (10Year). In Vol. 221 www.riskrewardblog.blogspot.com , I explained the correlation between these securities and the 10Year. But one thing that I have learned over the past few years is the value of patience. Before making a significant purchase or sale, I re-read previous editions of Risk/Reward that discuss similar moves in the past. I do so as a double check against what could be an emotional as opposed to a studied decision. This time I found Vols. 80, 99 and 174 www.riskrewardblog.blogspot.com instructive. Another thing I have learned is to avoid large moves “Come Monday.” Monday markets reflect an entire weekend’s worth of euphoria and/or anxiety and in my experience overshoot, to the positive and to the negative, actual market sentiment. “Come this past Monday”, I decided to “hold tight”---and I am glad that I did.

In addition to my reticence to act on Monday’s in general, my review this past Monday of the world bond market influenced me to stand pat. As also discussed in Vol. 221 www.riskrewardblog.blogspot.com, bond markets are global and interconnected. As such, the prevailing rates last Monday for the 10Year bonds of France (1.585%), Germany (1.264%), Italy (2.698%) and Spain (2.673%) led me to conclude that the rate on the US10Year would not move much higher than the previous Friday’s close of 2.65%. Why would a rational investor buy Italian bonds with their inherent risk of default at a yield of 2.698% when one can purchase the safest bonds in the world at a yield of 2.65%? I was proven right as the US10Year yield moderated to 2.62% on Monday and fell steadily through Wednesday’s close of 2.55%. Due to the correlation between my portfolio and the 10Year, that movement translated into some excellent gains for me. And as Thursday dawned, I received even more positive vibes; this time in the form of “Portuguese love.” News of possible financial trouble from that small nation sent tremors throughout the Eurozone. The resulting flight to safety by bond buyers caused the price of the US 10Year (and those securities priced in relation thereto) to rise as its yield dropped to 2.53% by that day’s close and to 2.52% at week's end.. It was like Europe was ‘saying to me/love me baby.”

For those who pay attention to financial news, investor “complacency” and its cohort, the lack of volatility, continue to be hot topics. Commentators warn that the steady upward momentum in asset prices, nurtured by highly accommodative monetary policies, has created asset bubbles in every financial market. The ”q and a” session last week between Fed Chair Janet Yellen and IMF President Christine Lagarde has heightened this concern. In that session, Chair Yellen stated that tightening monetary policy was NOT the first line of defense against “financial excesses” (bubbles); macroprudential policy was; in the form of capital and lending requirements imposed on regulated institutions as coordinated by and between central banks. Good luck with that one, Janet. Very recent history has shown that there can be “chaos across the border.” Just look at the Eurozone sovereign debt crisis of 2011 which at the time was chronicled each week in this publication. (See May through December, 2011 editions). And as interconnected as the financial world has become, that chaos “one day could happen to us.” In the meantime, the ECB contemplates more accommodation in the form of its own quantitative easing; our zero bound policies keep our rates at historic lows; and investors the world round continue to venture further out the risk curve in search of yield. Someday the resultant bubbles will burst, and there will be no doubt this time as to who has “blood on their hands.”

Unlike Jimmy Buffett, I “know the reason” I stayed invested this week. I am not sure I will remain so “all season.” Any type of “pop top” could cause me to “blow out my flip flop” and sell, most notably a rise in interest rates. One thing is for sure. If I fail to preserve my year to date profits, “some people could claim that there’s a woman (Janet Yellen) to blame”, but “I know it will be my own damned fault.”

July 5, 2014 Measure of a Man

Risk/Reward Vol. 227

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“Back on the beat/Back to the start
Trust in your heart
That’s the measure of a man.”---lyrics from “The Measure of a Man” sung by Elton John

“Cause the fire don’t fear the water
And the night don’t fear a thief
Here we are/We are/We found euphoria”---lyrics from “Euphoria” sung by Usher

"There's no way out of this dark place
No hope/No future
Tell me where did I go wrong?"---"No Way Out" sung by Phil Collins

The second quarter came to an end last Monday so it is time to take "The Measure of the Man." Through the first six months of 2014, the two portfolios that I manage earned a total return (appreciation plus dividends, pre-tax but net of all expenses) of 9.6% and 8.4% respectively. It is satisfying to know that by "trusting in my heart", I have surpassed my annual goal of 6-7% in just two quarters. Come next Monday the choice I face is whether to be "back on the beat" or to liquidate and lay "back until the start" of 2015. With the yield on the 10 Year Treasury Bond (10Year) spiking to 2.65% following the excellent jobs reports of Thursday and Friday, the latter may be the wiser choice for an income investor like me, even as the Dow Jones Industrial Average (YTD total return of 4%) and the S&P 500 (YTD total return of 8%) hit record highs.

Will the seemingly endless string of new highs continue or are there difficult times ahead? A report recently issued by the Bank for International Settlements (BIS), the central bank for central banks, warns that current asset prices are not sustainable. The BIS characterizes the current market as "Euphoric", buoyed by central bank monetary policies which foster a belief that interest rates forever will be zero bound. According to the BIS, one consequence of such a belief is market complacency; a condition in which "the fire don't fear the water/And the night don't fear a thief." In support of its thesis, the BIS cites the fact that junk bonds now yield, on average, 4.8% (an all time low) and the fact that investment grade corporate bonds trade at a spread of less than 1% to Treasuries. According to the BIS, neither rate reflects an appropriate risk premium.

Whether or not the BIS's concerns are justified, one thing is for certain: as a result of new banking regulations, if interest rates do rise quickly, those seeking to exit bonds or bond funds may find "there's no way out/No hope/No future." Allow me to "tell you where the regulators went wrong." In the wake of the 2008-9 banking crisis, Congress and the Federal Reserve mandated that institutions covered by FDIC insurance (virtually every bank) curtail many non-core functions, one of which was making a market for bonds. Until this change, most large financial institutions maintained active bond trading departments that literally served as the bond buyer of last resort. Banks were deemed to have sufficient capital to inventory the bonds they purchased until prices rose to a profitable level. With today's more restrictive capital requirements, those departments have been disbanded, and no effective replacement has been devised. Thus, should the price of bonds fall (because interest rates increase), the sharpness of the decline will be magnified by the absence of ready buyers a/k/a market makers. This is an additional reason to pare at least the bond fund portion of my income producing portfolio.

With new records being set each week, I find myself praying for just "One More Night" of gains. But with recent spike in the interest rate on the 10Year, "I can feel it (a drop in the value of income producing securities, that is) coming in the air tonight, oh Lord." And if that drop becomes too pronounced, like Phil Collins, "I can (and will) just walk away/Just leave without a trace."