June 1, 2013 Domino

Risk/Reward Vol. 172

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

"I don't ask for much/I only want your trust
And I know it don't come easy."---lyrics from "It Don't Come Easy" by Ringo Starr

"Oh oh Domino/Roll me over Romeo
There you go/Lord have mercy
I said oh oh Domino"---lyrics from "Domino" by Van Morrison

"Helter skelter in a summer swelter
The birds flew off with a fall out shelter
The players tried a forward pass
With the jester on the sidelines in a cast."---lyrics from "American Pie" by Don MacLean

The action in the bond and stock markets this week reminded me of the comments made last December by Ray Dalio, the most successful hedge fund manager in history. ( www.riskrewardblog.blogspot.com Vol. 148). Back then, Dalio boldly stated that the best profit making opportunity of his life had yet to arrive. According to Dalio, that opportunity would come when he sensed an end to QE3 at which time he would short Treasury Bonds and assets correlated thereto. (A short seller is one who borrows a security from another --usually a long term holder like a pension fund---in exchange for a small premium promising to return it on a date certain in the future. The borrower then sells the security at the current market price believing the price will fall before he is required to buy it back and return it. He profits from the difference in those prices. The more the price falls before the repurchase the more the profit.) I sense that Dalio has begun his move this week, and he looks like a prophet (or is that "profit").

An understanding of Dalio's opportunity "don't come easy." "I don't ask for much. I only want your trust" that I can explain it. So here goes. #1 Start from the premise that most income producing assets (e.g. bonds and high dividend paying stocks) are priced in relation to the safest fixed income investment in the world which currently is the 10 year U.S. Treasury Bond, behind which stands the full faith and credit of the United States. Given the choice between a Treasury Bond paying a 2% yield and a corporate bond paying 2%, a rational person will choose the Treasury because a corporation could default on its bond obligation (e.g. Lehman Brothers) while it is almost certain that the United States will not. #2 Consequently, corporate bonds generally pay a higher yield than Treasury bonds. Otherwise no one would buy them. Dividend paying stocks, which unlike bonds have no claim to assets in a liquidation scenario, must promise an even higher yield or the prospect of price appreciation. Again, these ascending rates of return are necessary in order to compensate investors for the corresponding increase in risk associated with each asset class as one proceeds up the risk curve. That curve ascends from Treasury bonds to investment grade corporate bonds to high yield or junk bonds to preferred stocks to common stocks a/k/a equities. #3 Understand that stock and bond prices rise or fall inversely to their yield. That is, the higher the price of the stock or bond, the lower the yield. For example, if a stock priced at $100 pays a dividend of $5 annually it has a 5% yield. If the price of that stock goes up to $120, it has a 4.17% yield ($5/$120= 4.17%) #4 Appreciate that many investors do not hold bonds to maturity. They buy and sell them based on the then prevailing interest rate. For example, a 10 year Treasury Bond purchased for $1000 and paying $40 in interest (or 4%) will continue to be worth $1000 so long as the prevailing rate is 4%. If the prevailing interest rate falls to, say 3.5%, that 4% bond will be worth $1142 ($40/$1142=3.5%). Conversely, if the prevailing interest rate increases over the 4% rate, the bond price will fall. # 5 Under QE3, the Federal Reserve has been up-bidding the price of longer term Treasury Bonds, buying $45 billion worth of each month's issuance (roughly 60% of the long term bonds available to be purchased) thereby depressing the yield on the 10 year Treasury Bond to 2% or below. For context, historically, 10 year Treasury Bonds have yielded 4-6%. #6 Due to this low yield (once again caused by the Fed bidding up the price), 10 year Treasury Bonds currently are not attractive to many investors (like me) who need a higher return. As a consequence, people (like me) who normally would have a large percentage of their assets in Treasury Bonds are forced to move up the risk curve to corporate bonds, junk bonds and/or stocks. Indeed this is the intended purpose of QE3---to force more private investment in corporations thus spurring the economy and creating jobs. With more people buying those riskier assets, their prices, in turn, have been bid up and their yields correspondingly lowered. For example, junk bonds yielding 10% last year, yield less than 6% this year, an historic low. #7 If and when the Fed slows or quits its $45 billion monthly buying spree, the price of the 10 year Treasury Bond will fall like a rock since the participant which has been buying 60% of the offerings (the Fed) will have left the market. Income producing assets described above, priced in relation to Treasuries, will also fall in value. Investors who time the sale of their bond and/or income producing assets in front of that fall will do well. And short sellers like Dalio will make out like bandits.

So how does the above tutorial relate to today's bond and stock markets, "Romeo"? As reported last week, the minutes of the May Federal Reserve meeting released 10 days ago indicated that, due to an improved economy and concerns about long term inflation, QE3 purchases may taper off as early as June. In response, many significant holders and/or borrowers of Treasury Bonds (perhaps Mr. Dalio) sold them, capturing profits in front of any tapering. The selling continued this week as 10 year Treasury Bond prices plummeted. Inversely, their yields spiked from 1.6% in early May to 2.23% on Wednesday, a rise of 37%! "Lord have mercy." This front running Treasury Bond selling caused a "Domino" effect up the risk curve. With the interest rates on 10 year Treasury Bonds rising, the historic low yields on assets such as junk bonds and dividend stocks are suddenly less appealing and thus worth less. As noted last week, the first to fall in price were those investments directly correlated to low Treasury rates such as mortgage real estate investment trusts (RQI, a closed end fund comprised of mREITS fell 14% in 7 trading days), and business development companies (FGD, a closed end fund comprised of BDC's fell 6% in the same time period). Over that period, bond-like stocks such as utilities and blue chip dividend payers have taken it on the chin with both NGG and JNJ falling 5%. So "there you go." As Van Morrison says, "oh, oh Domino"

So how does this impact me? In advance of the "summer swelter", with the stock market in general going "helter skelter" and with my favorite niche, dividend stocks, suffering declines greater than the general market, I decided to sell most of my positions, thereby capturing profits and raising cash. In addition to selling my REITS, BDC's and leveraged funds on Tuesday (as I wrote that I would last week), I also sold junk bond funds and those dividend payers that had run up nicely over the past few months. By Wednesday afternoon, I had sold all but PGF, PGX, CTY and GSTpA. My ground game is fine. I don't need to complete a "forward pass". My annual benchmark is 6% pre tax, and I am well above that now with 7 months to go. So, this "jester is on the sidelines" for a while, content to see what happens. Rest assured, I will be back, and maybe sooner rather than later. I am not "in a cast." I may even join Mr. Dalio on the short side. But, when good economic news (home price increases) is bad for the stock market (see Wednesday's action), and when bad economic news (rise in jobless claims) is good for the stock market (see Thursday's action)---all because the former means a quicker end to QE3---it's time for me to kick back, to switch on some Van Morrison and to do some chill-axin' with my "Brown Eyed Girl."

P.S. Oh, and as for Friday's last minute sell off, I have heard several excuses: reaction to the threat of tapering, month end rebalancing, panic, etc.---but no solid explanation. All the more reason to have sold.