Risk/Reward Vol. 343
THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN
I am publishing tonight because I am catching a morning flight to Colorado for a combination subscriber conference/ski trip.
Say what you will about The Donald, Mr. Market loves him. Rarely have we seen a day like the one following the State of the Union address. And no one has seen as rapid a 2000 point rise in the Dow Jones Industrial Average . The Dow hit 19,000 for the first time on November 22, 2016 and hit 21,000 on March1st.
To be fair, it may not all be attributable to President Trump. Also on Wednesday, several Federal Reserve governors reacted to the latest inflation numbers and proclaimed that it is time for a rate increase. Indeed, the likelihood of a March hike rose from 30% (as reported last week) to over 80%. Investors sold 2Year Treasury Bonds like they were going out of style. As a result, the yield on the 2Year reached 1.3% for the first time since 2009. And most of that money was plowed into equities. The yield on the all important US Ten Year Treasury Bond ("10Year") was slower to react but still rose to over 2.5% immediately following Fed Chair Yellen's hawkish speech on Friday.
The developments in the bond market midweek provided the impetus to sell the majority of my holdings. Most were interest rate sensitive such as preferred stocks and preferred stock closed end funds. I will await the conclusion of the Fed's March meeting before deciding if and when to re-enter. If a rate reset occurs and/or clarity as to future increases is provided I will buy.
So why sell when Mr. Market is going through the roof? Why, because I do not invest based upon stock prices. I am wholly guided by movement in the 10Year. Allow me to explain.
Over the years I have struggled with investments. I have hired and fired advisors. For a while, I adhered to Bill O'Neill's CANSLIM strategy. I even day traded for a while. Despite several missteps, including riding the dotcom roller coaster all the way to the bottom, I arrived in 2010 with enough accumulated capital that I could contemplate retirement. My goal was to do so without invading principal which was achievable if I earned an annual pretax return of 6% on the portion of our funds which I manage. More important than any return however was our mutual desire to minimize risk.
As I explained in June, 2010 (Volume 1 www.riskrewardblog.blogspot.com ), achieving a nearly risk free 6% return would have been a layup during most of my life. From 1969 through 1997, the yield on the 10Year (considered by investors world wide as the closest to a risk free investment) rarely fell below 6%. From 1980 through 1985, the yield did not fall below 10%. But since the 2008 financial crisis, the yield has rarely exceeded 3%, has often been below 2% and currently sits at 2.5%.
So how does one achieve a 6% pre tax return with the least amount of risk?
Why not buy and hold an S&P 500 index fund like SPY? After all, SPY is up 6.4% year to date and up over 19%% over the past 12 months. That's true, but if one looks further back into history one discovers that its recent performance notwithstanding, SPY has averaged a compound annual return of only a little over 7% these past 10 years. And lest we forget, SPY dropped over 35% in 2008. It has achieved that nice 10 year average only because of some healthy double digit years. In short, SPY is hardly risk free and certainly is volatile.
So, again, how can one achieve a 6% pre tax return with the least amount of risk?
I have come to believe that one can construct a non-diverse portfolio correlated to a market singularity (the 10 Year) with movement by that singularity providing clarity on when to buy, hold or sell. I submit that by maintaining daily vigilance, adhering to strict principles and fearing not, the buying and/or selling, in short order, of some or all of one’s portfolio, one can achieve a 6% return with minimal risk. I do not buy the 10Year. Instead, I buy higher yielding securities that are very closely correlated to the 10Year. For example, through study and observation, I know that highly regarded preferred stocks maintain a roughly 320 basis point (3.2%) spread to the yield on the 10Year. Thus if the yield on the 10 Year remains stable at 2.5% one can achieve a 5.7% return by merely holding a basket of highly rated preferred stocks (such as found in the exchange traded fund PGX) and collecting dividends. If the yield on the 10 Year declines, in time, the yield on these preferred stocks will also decline ultimately reaching equilibrium at the aforementioned 320 bp spread. As a result, an investor will enjoy a capital gain. (Remember the price of an interest rate sensitive security increases as the yield declines.) If the yield on the 10Year increases or one reasonably can anticipate such an increase, one sells thereby retaining any accrued dividends and reaping the aforementioned capital gain. One then waits on the sidelines, safe and sound in cash, until stability returns to the 10Year and hopefully ahead of preferred stock equilibrium.
Here is a real life example. Anticipating a rate increase by the Federal Reserve back in December, I was on the sidelines in cash. When the increase was announced, the market overreacted as it invariably does. The yield on the benchmark 10 Year spiked to over 2.6% as its price tanked. (Remember the higher the yield on a bond the lower the price.) The price of correlated securities such as preferred stocks also tanked. I swept in and purchased them en masse at bargain prices. The rate on the 10Year ultimately stabilized below 2.5% and the above discussed equilibrium ensued thereby providing me a capital gain. I held tight until this past Wednesday when I sold in anticipation of an upcoming rate increase. Between principal appreciation and dividends I am up 5% on my invested capital in just over 2 months. Achieving another 1-2% this year should be a cake walk once stability returns to the bond market since the portfolio I will repurchase pays healthy dividends, many on a monthly basis.
I also invest in other interest rate sensitive securities such as exchange traded debt and certain leveraged closed end funds which are also correlated to the 10Year. The oil stocks I buy are correlated to the price of oil more than to the rate on the 10Year. I did not sell my oil stocks.
This approach reads more complicated than it is. In any event, it helps me sleep peacefully each and every night.
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