July 5, 2014 Measure of a Man

Risk/Reward Vol. 227

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

“Back on the beat/Back to the start
Trust in your heart
That’s the measure of a man.”---lyrics from “The Measure of a Man” sung by Elton John

“Cause the fire don’t fear the water
And the night don’t fear a thief
Here we are/We are/We found euphoria”---lyrics from “Euphoria” sung by Usher

"There's no way out of this dark place
No hope/No future
Tell me where did I go wrong?"---"No Way Out" sung by Phil Collins

The second quarter came to an end last Monday so it is time to take "The Measure of the Man." Through the first six months of 2014, the two portfolios that I manage earned a total return (appreciation plus dividends, pre-tax but net of all expenses) of 9.6% and 8.4% respectively. It is satisfying to know that by "trusting in my heart", I have surpassed my annual goal of 6-7% in just two quarters. Come next Monday the choice I face is whether to be "back on the beat" or to liquidate and lay "back until the start" of 2015. With the yield on the 10 Year Treasury Bond (10Year) spiking to 2.65% following the excellent jobs reports of Thursday and Friday, the latter may be the wiser choice for an income investor like me, even as the Dow Jones Industrial Average (YTD total return of 4%) and the S&P 500 (YTD total return of 8%) hit record highs.

Will the seemingly endless string of new highs continue or are there difficult times ahead? A report recently issued by the Bank for International Settlements (BIS), the central bank for central banks, warns that current asset prices are not sustainable. The BIS characterizes the current market as "Euphoric", buoyed by central bank monetary policies which foster a belief that interest rates forever will be zero bound. According to the BIS, one consequence of such a belief is market complacency; a condition in which "the fire don't fear the water/And the night don't fear a thief." In support of its thesis, the BIS cites the fact that junk bonds now yield, on average, 4.8% (an all time low) and the fact that investment grade corporate bonds trade at a spread of less than 1% to Treasuries. According to the BIS, neither rate reflects an appropriate risk premium.

Whether or not the BIS's concerns are justified, one thing is for certain: as a result of new banking regulations, if interest rates do rise quickly, those seeking to exit bonds or bond funds may find "there's no way out/No hope/No future." Allow me to "tell you where the regulators went wrong." In the wake of the 2008-9 banking crisis, Congress and the Federal Reserve mandated that institutions covered by FDIC insurance (virtually every bank) curtail many non-core functions, one of which was making a market for bonds. Until this change, most large financial institutions maintained active bond trading departments that literally served as the bond buyer of last resort. Banks were deemed to have sufficient capital to inventory the bonds they purchased until prices rose to a profitable level. With today's more restrictive capital requirements, those departments have been disbanded, and no effective replacement has been devised. Thus, should the price of bonds fall (because interest rates increase), the sharpness of the decline will be magnified by the absence of ready buyers a/k/a market makers. This is an additional reason to pare at least the bond fund portion of my income producing portfolio.

With new records being set each week, I find myself praying for just "One More Night" of gains. But with recent spike in the interest rate on the 10Year, "I can feel it (a drop in the value of income producing securities, that is) coming in the air tonight, oh Lord." And if that drop becomes too pronounced, like Phil Collins, "I can (and will) just walk away/Just leave without a trace."