Risk/Reward Vol. 283
THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.
Due to familial obligations, I am not publishing a typical column this week. However, as a result of the blockbuster jobs report issued on Friday, the likelihood of the Federal Reserve raising interest rates in December soared. Indeed, pundits are placing the odds at 70% or higher. Such a development deserves some reflection.
As a student of correlation (more about that in a second), Friday played out in a predictable manner. The likelihood of a rate increase triggered a spike in bond yields. The yield on the US two year Treasury bond jumped to a five year high, and the yield on the 10 Year popped above 2.3%. This of course caused a concomitant drop in bond prices and in the prices of those securities that trade in correlation thereto. (Remember, in the bond and interest rate sensitive world higher yields means lower prices). Thus real estate investment trusts (REIT's), utilities, preferred stocks and a host of other rate sensitive securities took it on the chin. The prospect of increased rates also caused the dollar to strengthen in relation to other world currency. When this happens, the price of oil, which is denominated world wide in dollars, typically falls which it did yesterday. In turn, oil stocks tanked.
As reported last week, the heightened likelihood of this scenario contributed to my recent decision to sell my holdings in oil, REIT's and other rate sensitive securities. Had I not, my profits would have been halved last week. Ironically, based on my study of correlation, these sectors now may be oversold. If this situation continues into next week, I may not wait for the actual rate increase to re-enter.
Displayed below is an excerpt from Vol. 221 (www.riskrewardblog.blogspot.com) which explains in more detail my correlation theory.
"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 )"
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