May 10, 2015 See The Exit

Risk/Reward Vol. 266

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


“So Goldilocks for a while

 Would you mind

 Smiling your perfect smile”---lyrics from “Goldilocks Sometimes” sung by The Monkees



“A weather man of words

 But I could never shoot down

 My high-flying bird”---lyrics from “High Flying Bird” sung by Elton John



“Baby see the exit, exit, see the exit, let's go, out this club

 Exit, exit, exit, see the exit, let's go out this club, exit”---lyrics from “Exit” sung by RKelly



Who would have thought that a so-so April jobs report on Friday would vault the Dow Jones Industrial Average (DJIA) 1.5% (267 points) and the S&P 500 1.35% (28 points)?   Only Mr. Market.  The economy added a respectable 223,000 jobs last month, and unemployment fell to 5.4%. But the job participation rate remained at an historic low (only 62.8% of eligible workers were employed or looking for work), and wages grew at annual rate of only 2.2%, far below the 3-3.5% that labor economists believe is necessary to sustain healthy economic growth. So why the bump? Market commentators called the jobs report  “Goldilocks”: “ not too hot” so as to cause the Federal Reserve to raise interest rates before September; “not too cold” so as to indicate a stalled economy; “just right” for the market to trade within its year-to-date range.   And so, the stock market's steady downward march over the previous few days was halted and reversed by the Labor Department’s “perfect smile” jobs numbers.


And what a reversal it was from Tuesday and Wednesday when the DJIA sank 239 points (and even more intraday).  The market declined in the aftermath of comments from Fed Chair Janet Yellen early in the week that “equity market valuations were generally quite high.” Talk about “a weather man of words/shooting down/a high flying bird!”  Clearly, whatever else one believes impacts the stock market, one cannot deny that the Fed is influence numero uno.  A few negative words from Janet and the market lost all of its year to date gains; two days later a jobs report indicating that the Fed may not raise rates until September caused the indices to flirt with all time highs.  I believe that these “mixed signals,” about which I wrote last week (www.riskrewardblog.blogspot.com ), will cause the markets to yo-yo until the Fed makes a definitive move.


The bond market mirrored the stock market’s action with the yield on the bellwether 10 Year US Treasury reaching as high as 2.24% midweek before falling to 2.15% at Friday’s close. (Remember: as yields increase, prices decline.)  However, on a percentage basis, the bond market is much more volatile and will remain so until the Fed raises rates. The reason is simple and has been the subject of recent comments from virtually every market guru from Bill Gross to Jeffrey Gundlach to Mohamed El Erian to Stanley Druckenmiller to Larry Summers to Howard Marks to most recently Jamie Dimon, the head of JPMorganChase.  And that reason is this:  a lack of liquidity---which is a fancy way of saying there won’t be enough buyers when everyone wants out of bonds and starts yelling “ Baby see the exit, exit, see the exit, let's go, out this club/Exit, exit, exit, see the exit, let's go out this club, exit.” In the past, large banks (e.g. Citibank, JPMorganChase, Wells Fargo, Deutsche Bank, etc.) served as the buyers of last resort or “market makers” for all types of bonds. Historically, this role had been profitable for large banks.  At the same time, the role served to stabilize the bond market. But market making, in the short run, can and has exposed these institutions to significant risk; the type that occurred in 2008-2009 when the bottom fell out of all markets necessitating government assistance. The Dodd-Frank law was enacted, in part, to address the bond trading risks faced by banks, in particular the large ones such as Citibank which were deemed “too big to fail.” In typical regulatory fashion, however, Dodd Frank appears to have overshot the mark and now, in a classic example of “unintended consequences”, Dodd-Frank has created a bond market powder keg.  Without large banks serving as market makers, buying when others don't want to and backstopping prices, the bond market likely will fall precipitously once the Fed raises rates.  This is the main reason that income investors (preferred stocks, REIT's, municipal bond funds, utilities, etc.) such as yours truly, whose securities trade in relation to the bond market, must remain cautious and vigilant.  And why, Dear Readers, I remain overweight in cash.


And so the beat goes on--- with the stock and bond markets down significantly one day; up significantly the next. I see this pattern continuing until the greatest influence on Mr. Market's conduct, the Fed, finally raises rates. Like The Monkees, of this “I’m a believer/Not a trace of doubt in my mind.” Unless, of course, I change my mind.