Risk/Reward Vol. 221
THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.
“Some day we'll find it
The rainbow connection
The lovers, the dreamers, and me”---lyrics from “Rainbow Connection” sung by The Muppets
“Hands on your knees/Hands on your hips
Hands on your shoulders/Hands on your head
Up, down, turn around.”---lyrics from “Up, Down, Turn Around” sung by The Wiggles
“And don’t speak too soon for the wheel’s still spinnin’
And there’s no tellin’who that it’s namin’
For the loser now will be later to win
For the times they are a changin’”---lyrics from “Times They Are A Changin’” sung by Bob Dylan
Modern portfolio theory posits that an investor can maximize his/her return and minimize risk through asset diversification. In other words, by creating a portfolio of assets that move in different (even opposite) directions in response to any given market stimulus one can lower one’s risk and still profit. I get the theory. But, it just isn’t right for “ lovers, dreamers or me.” I have come to believe that one can construct a non-diverse portfolio correlated to a market singularity; with movement by that singularity providing clarity on when to buy, hold or sell. I believe that my “some day to find” that singularity, the “rainbow connection” if you will, has arrived. No surprise to my readers, the singularity of which I write is the yield on the 10Year US Treasury Bond (10Year). I further believe 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 prosper. In sum, predictability is more important to me than diversification.
Allow me to elaborate As loyal readers now know,” hands on your knees/hands on your hips/hands down” the benchmark interest rate against which all income securities are priced or spread is the yield on the 10Year. Based upon observation and study over the past three years, “hands on your shoulders/hands on your head/ hands down” the asset class most correlated to movement in the 10Year yield or rate is preferred stock. This is understandable since preferred stocks are a pure interest rate play and absent credit risk are unaffected by the performance of the underlying issuer. Stated alternatively, any change in the price of a credit worthy preferred stock is driven almost exclusively by the interest rate on the 10Year. Indeed, on most days I can tell whether my preferred stocks are “up or down” by simply looking at what happened to the yield on the 10Year. or vice versa Moreover, having studied and confirmed this correlation, I have increased my preferred stock income by buying preferred stock closed end funds (e.g. FFC, HPF, JPC) which enhance returns through leverage. To me, the risk associated with these leveraged funds is no greater since the correlation to the 10Year remains the same. Similar correlations to the yield on the 10Year obtain for mortgage real estate investment trusts, triple net lease investment trusts, leveraged bond funds, leveraged senior loan funds, leveraged municipal bond funds, leveraged utility funds and a host of other income securities. On average this portfolio pays an 8% annual dividend. In addition, I look for stocks or funds that distribute dividends monthly because a corollary to owning a portfolio singularly correlated to the yield on the 10Year is that one must be prepared to sell everything once the prevailing winds shift, and the yield on the 10Year starts to rise. This is what happened during the “taper tantrum” last summer when the yield on the 10Year went from 1.63% on May 2 to 2.16% on May 31 to 2.6% on July 5. Once the upward direction of that movement was confirmed (remember: upward yield means downward price), liquidation of the portfolio was in order (See Vol. 172 www.riskrewardblog.blogspot.com ). That wholesale departure was made more palatable by the receipt of monthly dividends which meant that I was not leaving a juicy quarterly dividend behind. In time, the yield on the 10Year stabilized, the typical spreads returned and I re-entered en masse. (See Vol. 200 www.riskrewardblog.blogspot.com ) If and when the 10Year yield begins to inflate in the future, I will sell and await stability again. It's a win/win because all that I have wanted from the beginning of this journey is a decent rate of return on government bonds (see Vol. 1 www.riskrewardblog.blogspot.com )
Some observations on the week:
1)Speaking of winds shifting (and metaphor mixing), the “times they are a changin’” in the oil patch. This week Energy Secretary Ernest Moniz and White House Senior Counselor John Podesta each confirmed that the President is considering lifting the 40 year ban on exporting crude oil. I’m not “speakin’ too soon for the wheel’s still spinnin’/And there’s no tellin’ who that it’s namin’.” But, it appears that “losers now” (namely the producers of light sweet crude not universally suited for refining in the US) “will be later to win” if they are allowed to export. Indeed, the news caused oil and oil related shares (e.g. pipelines, oil services and especially frac sand miner, HCLP) to soar on Wednesday even as most of the market fell.
2)Thursday's Wall Street Journal reported that "central bankers and investors" are "confounded by the persistently sluggish economy" and the drop in yield on the US 10Year. Really? An economy needs demand before it can grow, and consumers drive demand. Where are the consumers? This week, respected bond fund manager Jeff Grundlach and last week, Bond King Bill Gross each restated the obvious. Consumer demand declines as populations age and shrink. Look at Japan and Europe. We are not far behind. As for the yield on the US 10Year, please understand the following: 1)the bond market is global and 2)demand for bonds drives prices up and yields down. One third of all bonds issued by the United States are owned by US agencies which are required by law to keep their reserves in Treasury securities (e.g. Social Security, Federal Reserve, Military Pension Fund, etc.), 1/3rd are owned by US citizens and institutions (the guidelines of which also require a large percentage of assets be held in bonds) and 1/3rd are owned by foreign nationals and governments. If you are required (or of a mind) to own bonds, would you rather own the US 10Year paying 2.5% or Italy's 10Year paying 3.06% or Spain's paying 2.95% or France's paying 1.78% or Germany's paying 1.33% or Japan's paying 0.57%?
3)I was in the car most of Thursday listening to CNBC and Bloomberg Radio. One would have thought the financial world was collapsing---two days after record highs on both the Dow Jones Industrial Average and the S&P 500. Financial news stations are convenient, but like all 24 hour news outlets, they are given to hyperbole.
4)Although the headline news on Friday was that new housing permits jumped in April, the gain came exclusively in multifamily construction. Single family home construction remains in the dumps. Long term, this does not bode well for the economy.
Year to date, including dividends, the Dow Jones Industrial Average is even and the S&P 500 is up only 2%. The stock market is range bound. In contrast, my non diverse portfolio of income securities correlated to the 10Year (plus some oil/gas stocks) has exceeded my annual goal of 6%. That said, like Dylan,
“I ain't lookin' to compete with you
Beat or cheat or mistreat you
Simplify you, classify you
Deny, defy or crucify you
All I really want to do
Is, baby, be friends with you.”
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