Market Commentary for the week of June 17, 2013

Where from here?
With the markets trading at “all time highs” and investors scurrying to find alpha, much is being made about the demise of the bond market.  Analysts and economists are in accord that the age of bond appreciation is over.  The cause?  Global austerity and national treasuries forcing (holding) interest rates down to their lowest levels in generations.

 We know from quantitative studies that no trend is eternal. In fact most, if not all, market phenomena are cyclical, meaning they traverse a parabolic wave measured on an axis which either rises or falls.  To that extent, my research corroborates the common thought that we have most likely seen the last gasp of capital gains from bonds.  Does that mean that we know when, or if, the cycle inverts and yields start to rise?  Not necessarily.

But because of these perceptions, not rules, the whole of the bond market is being thrown under the bus.  While it is true that yields are down, total return from a well managed, diversified, laddered bond portfolio is still possible.

And yet, investors find themselves clamoring for “yield” from a variety of alternatives including ETF’s, limited partnerships, hedging, emerging market credit, and stocks.  I, too, have advised traditional risk-averse clients that as bonds mature, or are “called-back” by their issuer, we must seek to augment baseline dividend and interest payments with newer, perhaps riskier, alternatives in yield oriented equities.  If done prudently, it is a tradeoff worth the additional risks.

Being correct….or safe?

However, the market seems to have closed its eyes to the difference between theory and practical execution.  Secular market changes take decades to effect.  One can slowly rebalance risk in a portfolio without discarding an asset class outright.  Besides, higher interest rates would be the best barometer of a bullish economy than any metric one might glean from new highs in the stock market.

Recall, that bond prices are not necessarily why we buy bonds in the first place.  Yes, it’s great to buy bonds at a discount to par in a declining interest rate environment.  However, that’s not where we are today.  Clients who yearn for the 1990’s are stuck in a time-warp of unrealistic expectations. If yields do go up, the demand for bonds will be equally as great as that for stocks.  The counter balance of rebuilding dividends in bond portfolios will more than offset the potential of declining prices in existing bonds held.

If the economy were to heat up (?), loan demand and rising rates would be part of a new landscape.  It will take time to confirm these data, so please don’t think the “bond ship” has already sailed.  Too often our 24 hour news cycle and access to information makes us think that we’ve missed out on the upside, or, worse, that a looming crisis is imminent.  Such rash emotionalism is not worth jeopardizing one’s long-term portfolio construction.  It’s never really “different this time”, nor do “feelings” ever meld well with mathematics and data analytics.

Wrong focus.

When assessing these new paradigms of yield it is best to have historical and cyclical data.  Are these simply the best options at the present time or do we have valuable information to predict their performance during all possible sector, secular, and cyclical phenomena?  I would argue that the current crop of alternatives are reputed to be of good quality but that they might have risks which we cannot quantify.  For example, how many “bond funds” also have stocks in their portfolio?  The idea that all of Wall Street is now looking at new alternatives for yield is anathema to our desire for empirical methodological consistency.

Preserving principal and generating portfolio gains are sometimes distant cousins.  If a client expects “no risk” and loses money in a “secure” bond portfolio, their expectations are not being met.  An early mentor of mine always reminded me that we are in the business of managing expectations just as much as we attempt to manage/create alpha.  I still admonish clients to stay consistent in your discipline and to take a deep breath before jumping in the pool.  Despite assertions to the contrary, hazard lies in trying to synthesize alternatives to traditional fixed income portfolios.

Market Commentary for the week of June 3, 2013

Happy days.
Recent history has shown us that when investors feel “prosperous” their spending habits become more robust.  Sometimes they even throw caution to the wind and splurge on discretionary purchases they previously sought to avoid or postpone.  Such is the nature of a rapidly changing landscape that what previously had been a vulnerability now becomes a necessity.  The impact of financial decision-making can have a manic effect upon virtually any part of the world.  This is why crises become epidemics, and cures become panacea.

The recent market calamity prompted one of this generations most prolific negative responses, bringing back memories of the 1929 crash.  The most worrisome aspect of the current “magna-response” is that unlike a generational, tectonic fundamental response to what ailed us, the environment was ripe for one-off cherry picking of depressed stocks (and sectors) so that the catalyst for systemic change was never required.  If we only had the patience, and the will, to address some of the broader reasons for the selloff in the first place…

By comparison, the market today is poised to run up against valuation expansion in a dramatic way.  Though we may not realize it, this is not a “golden age” for stocks. To be sure, there is a multiplicity of opportunity in a variety of sectors and global regions, the fruition of which might take decades.  But, unfortunately, no one wants to think about generational transpositions in this minute-by-minute society.  So the ambiguities of long-term investing morph into a “what have you got today?” wellspring of uninformed choices.  Pretty soon, portfolios get locked-in and illiquid.

All-in.

Is the market discounting or pricing-in the real landscape of today’s fundamentals?  Well, the answer obviously depends upon your discipline, frame-of-reference, and time horizon.  In an all-or-none world the market appears to be well balanced, recognizing an appropriate “upside bias” towards owning stocks and bonds.

On the other hand, a more likely scenario would say that manias are not good, up or down, and that a gap between prices and relative strength ratios seems to be widening as prices, and optimism, race skyward.  If it always takes a “worse-case” scenario to define a potential market recalibration, one only has to look at the dot.com euphoria of a decade ago to refute that point.

Profit by accident?

The current surprise is that if fundamentals and prices are alright, why do so many households and small businesses still struggle to increase margins?  Is it only for the megaliths to succeed, or can the crescendo of upside enthusiasm effectively spill over to a broader capital base?

Remember, the averages were down over 40 percent.  A full rebound only brings us back to “square one” as far as valuations are concerned.  Consider that the Dow and S&P new highs were also within reach 5 years ago.

There are domestic and fundamental issues left to address that dramatically impact upon near-term concerns about whether we can sustain current equity prices and the mindset which drives them.  Amid hopes that this time is “for real,” take note that solutions don’t happen by accident, nor do market troughs.  The predominant trend always recedes back to the mean, just as market disasters always capitulate upwards.  Today, it seems, is a case of forgetting the root cause of the decline to the exclusion of a “feel-good” story.

This suggests that the current environment is not one which in and of itself could spark a recession or a turbulent reversal in the financial markets.  Rather, it contains the elements which, if left unattended, could produce an unexpected consequence of our boldness and impose a de-stimulative impact upon equity valuations.  The data are not enough to cause a global slowdown, but they are, at their core, a source of consternation which would make today’s new highs a possible resistance point for the future.