June 7, 2014 The Happening

Risk/Reward Vol. 224

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

“Hey, life look at me/I can see reality
Cause when you shook me/Took me out of my world
I woke up/Suddenly I just woke up
To the happening.”---lyrics from “The Happening” sung by The Supremes

“Why can’t you tell this boat is sinking?
Tell me…Why
Tell me…Why”---lyrics from “Why” sung by Annie Lennox

“I’m out on a limb
I’m giving in
I’m selling out.”---lyrics from “The Sellout” sung by Macy Gray

Two weeks ago, I wrote (Vol. 222 www.riskrewardblog.blogspot.com):

“It was a good week for growth and income investors alike. I see a day soon, however, when the interests of these two investment approaches diverge. I am betting that growth stalls, interest rates stay low and income securities benefit. If I am wrong, I will exit before my holdings (in the words of that marvelous lyricist, Lil Jon) “Skeet, skeet/Get low/Get low.”

I cannot speak to future growth, but “Hey, life look at me/I can see reality”—at least when it comes to interest rates. And the movement in the yield on the all-important US 10 Year Treasury Bond during the first three days of this week “shook me/Took me out of my world.” On Wednesday, “I woke up/Suddenly I just woke up/To the happening.”

What happened? The interest rate on the 10Year rose from 2.46% last Friday to 2.53% on Monday to 2.59% on Tuesday. On Wednesday morning, disappointing trade deficit numbers were reported which commentators thought would send the 10Year rate down. Instead the 10Year rate jumped to 2.61% which of course sent the price down . “Tell me…Why/Tell me…Why/this boat is sinking?” Perhaps rates below 2.5% simply are not sustainable. Perhaps the market fears a mid-summer rate tantrum like last year. Perhaps the bond market has become a bubble as suggested by Federal Reserve officials quoted in Jon Hilsenrath's Wall Street Journal article Wednesday morning. To me, the “Why” is less important than the fact that rates appear to be rising. And that fact was confirmed on Thursday when the unprecedented, rate-suppressing action by the European Central Bank in 1) lowering interbank borrowing rates to 0.15% and 2) charging a negative deposit rate had little impact on the US10Year rate which ended the day at 2.58%. Friday's jobs report was better than expected and not surprisingly the 10Year rate rose to 2.60%.

Having achieved my goal for the year (over 6%), there is no reason for me to be “out on a limb” while the now volatile 10Year settles into a new, normal interest rate. So, with respect to those securities that are most directly correlated to the interest rate on the 10Year (e.g. preferred stocks, preferred stock closed end funds and mortgage real estate investment trusts or mREIT’s), “I gave in” and “sold out”--- taking a handsome profit in the process. I held those in 401(k) and IRA accounts so there were no tax consequences associated with the sales, and the transaction costs in total were less than $200 ($9 per trade). After my “sell out”, I am 1/3rd in cash. Likely, I will stay that way until after the Federal Reserve meets later this month. Signals from that meeting could have a big impact on interest rates and by extension the value of interest rate sensitive securities. They did last year. If and when I perceive that the interest rate on the 10Year has stabilized, I will repurchase the securities that I sold--- thus preserving my profits while foregoing, at most, only a handful of monthly dividend checks. I view this time-out as cheap insurance against volatility. As for my other holdings (e.g. triple net lease REIT’s, oil and natural gas, pipeline master limited partnerships and leveraged closed end index funds), I remain invested. The stock market in general continues to move upward, and I want to participate.

As another record week for the S&P 500 and the Dow Jones Industrial Average comes to a close, I take comfort in where I sit. I have captured a “Supreme” return on my interest rate sensitive securities and still have exposure to growth stocks. Selling all or part of one's portfolio may be “Nothing But Heartache” for some, but I would rather take a profit than “Keep Me Hangin’ On” during a volatile period, especially one with a downward bias. “My World Is (Not) Empty Without Them” in part because I know that in time, these interest-rate sensitive securities will be “Back in My Arms Again.”