Risk/Reward Vol. 173
THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.
"I heard the news today, oh boy/About a lucky man who made the grade
And though the news was rather sad/Well, I had to laugh."---lyrics from "A Day in the Life" by The Beatles
"Everybody get to putting up your lighter now
Baby girl you see me shining much brighter now
Let's go to the next level."---lyrics from "Next Level" sung by Mary J. Blige featuring Busta Rhymes
"Where are you going now my love/Where will you be tomorrow
Will you bring me happiness/Will you bring me sorrow
On the questions of a thousand dreams/What you do and what you see
Lover, can you talk to me?"---lyrics from "Carry On" by Crosby, Stills and Nash
"Oh boy." On Monday and Tuesday, as "I heard the news each day", I accurately predicted the direction of the market. And it was not because I am "a lucky man who made the grade." On Monday, I simply recognized that "though the news was rather sad" (disappointing PMI numbers), the market would rise--- because, as noted last week, bad economic news increased the likelihood that the Federal Reserve will continue quantitative easing (QE3). On Tuesday, "I had to laugh" when I accurately predicted that the morning's good news (trade deficit numbers better than expected) would result in a market decline--- because that news lessened the prospect for continuing QE3. By Wednesday, however, whether the news was good or bad did not matter. Predictability gave way, as the uncertain future of QE3 dragged the Dow Jones Industrial Average (DJIA) down triple digits. Thursday's action was a roller coaster in advance of Friday's much anticipated jobs report--- which hit the sweet spot, 175,000 new jobs---high enough to indicate moderate economic growth, but not so high as to warrant tapering, at least not in the minds of the investing public. As a consequence, the DJIA skyrocketed, to end the week up 133 points. Curiously, it did so at the same time that the price of the 10 year Treasury Bond hit a 14 month low. As discussed over the past two weeks, recently, falling bond prices have resulted in lower stock prices across the board---but not on Friday. This uncoupling of bond and stock prices promises more unpredictability next week. How quickly markets change!
Unpredictability aside, recent market volatility has revealed some massively mis-priced assets; "babies" thrown out with the bath water. This situation is discussed at length in the book I just finished entitled "The Most Important Thing" written by noted investment advisor/billionaire Howard Marks of Oaktree Management. Marks' thesis is that turbulent times such as these produce opportunities that can be exploited if one can think on the "second level." Here is how the thesis works in real life. First level thinking led to the conclusion that I drew two weeks ago: to wit, because 10 year Treasury bond prices were falling quickly, income producing assets priced in relation thereto such as mortgage real estate investment trusts, junk bonds, and high dividend stocks would likewise decline quickly and should be sold if one wished to capture year to date profits. (Note: this correlation held true even yesterday as mortgage REITS, junk bond funds and business development companies continued to lose ground and utilities (VPU) traded 9% below where they were just two weeks ago--- even as the DJIA spiked.) Since income producing assets are among my favorites, I sold most of my holdings last week. Thinking on the "next (second) level" led to the observation this week that some of those disfavored assets would be oversold and thus mis-priced. Thinking on this level caused me to search for such opportunities and on Tuesday to buy FFC, a closed end fund that was massively underpriced. It is "shining much brighter now" and even rose on Wednesday while the rest of the market tanked. I used "second level" thinking on Thursday to locate and to purchase JPI, HPS and DUC. "Everybody get to putting up your lighter now!" (Email me if you want a more detailed description of my second level thought process.)
Even with the "second level" purchases discussed above, I am still 80% in cash which is where I likely will remain until there is more clarity on interest rates and/or QE3. Mr. Bernanke, "where are you going now, my love/where will you be tomorrow?" Will QE3 continue unabated or will tapering begin? I have "questions on a thousand dreams, what you do and what you see/Lover, can you talk to me?" And I am not alone. On Tuesday, Bill Gross, the founder of PIMCO and nicknamed by those in-the-know as the "Bond King," published his monthly Investment Outlook (available on PIMCO's webpage) in which he criticized QE3 and its unprecedented suppression of yields. According to Gross, its initial stabilizing aspects notwithstanding, QE3 now is negatively impacting investor appetite to "carry" risk. Even if risk is correctly priced on a RELATIVE basis (e.g. an appropriate spread between the yields on say, Treasury bonds and junk bonds), all yields are too low on an ABSOLUTE basis. Junk below 5% simply is not worth the risk; nor is committing $1000 for one year in a Treasury note for a paltry 0.14%; nor is buying a utility stock for a 3% return---especially when each can lose 10% or more of its value within a few trading sessions if and when the yield on the benchmark 10 Year Treasury Bond spikes (and its price drops) like it did in May. To quote Gross, "... never have investors received less for the risk they are taking." On Friday, former Fed Chair Alan Greenspan joined Gross' chorus and called for QE3 tapering to begin. Otherwise, according to Greenspan, other market participants may decide to abandon Treasury Bonds-- tapering or no tapering. If that happens, the Fed could lose sway over interest rates altogether which Greenspan believes would add further uncertainty to our fragile economy and more unpredictability to markets. Friday's drop in the price of the 10 year Treasury Bond despite the market's belief that QE3 will continue may portend this happening already. Keep your eye on Ray Dalio and his fellow Treasury shorts (discussed in last week's edition) who you can track by following TBT and PST!
And so I have concluded that except for an occasional purchase of massively mis-priced assets or a Treasury short, I am better off in cash. As more of us who favor high yielding instruments migrate there (junk bond funds experienced record outflows this week), maybe the Fed will conclude that QE3 has outlived its usefulness. Perhaps it is time for the Fed to start an orderly (albeit painful) taper while it still holds sway in the bond market, sway that Greenspan fears may be at an end. As Crosby Stills and Nash know, when it comes to tapering:
"It's been a long time comin', and it's goin' to be a long time gone."
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