CMG AdvisorCentral

Tactical investing news, views and resources for financial advisors

Beware: Rising Rate Environment

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Reminder for bond investors: When interest rates rise, bonds lose value.  I shared the following chart in July 2016 (interestingly just two days from the 1.37% low in yields).  It shows how much money is lost for every 1% increase in rates.  The top section is the 10-year Treasury bond and the bottom section is the 30-year Treasury.  (I know I’ve shared this chart with you several times, but I believe it is worth revisiting.  I just don’t believe the average investor knows just how much risk they are taking on with their so called “safe” investments.)

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1.37% was the low yield back on July 13, 2016. The 10-year Treasury is currently yielding 2.42% and the 30-year is yielding 3.02%.  That adds up to a -8.84% loss in value for the 10-year and call it a -16% for the 30-year.  Maybe rates move back down, but I’m not so sure.  I’m a bit more worried about what those losses will look like when yields rise to 3.4%, 4.4% and 5.4% (similar to where they were in 2007).  -30% is a real risk.

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College Endowment Returns Were Negative in 2016 and Negative Since 2007

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U.S. stocks have worked well since the 2008/09 financial crisis.  Modern Portfolio Theory – broad asset class diversification has not.  But I didn’t know it was this challenging.  I was somewhat surprised to see this from Bloomberg:

Endowments were hampered by investments in non-U.S. equities, which declined 7.8 percent, energy and natural resources, which lost 7.5 percent, and commodities and managed futures, which were down 7.7 percent.

Wealthier schools’ performance was dragged down by their larger allocations to riskier alternatives such as hedge funds. Hedge funds were among the worst performers for endowments of all sizes, with a 4.0 percent loss.

Endowments with more than $1 billion declined 1.9 percent, the same as the average.  The blue line tracks the performance.  Reflected are negative returns for 2016 and negative overall returns from 2007 – 2016:

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More from Bloomberg: Endowments were hampered by investments in non-U.S. equities, which declined 7.8 percent, energy and natural resources, which lost 7.5 percent, and commodities and managed futures, which were down 7.7 percent.

It causes one to think – who needs diversification anymore?  We likely need it most when the risk feels the least (like today) and need it least when the risk feels the most (like early 2000 and 2008/09).

Things just don’t smell right to me.  It feels like it is 1999 all over again.  This time we are witnessing a massive shift into low-fee passive (non-managed) index products.  Active money managers are taking it on the chin.

However, like all that money that raced to technology funds at the market peak in the late 1990’s.  The -75% tech wreck followed.  That same bad behavioral trend is alive and well today.  Stay risk minded.  It took 15 years and a 300% recovery gain to overcome that loss and get back to even.  Just saying…

Rising Inflation Pressures and What it Means to Your Bond Allocations

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Below is my “go to” inflation chart.  The Ned Davis Research Inflation Timing Model consists of 22 indicators that primarily measure the various rates of change of such indicators as commodity prices, consumer prices, producer prices, and industrial production.  The model totals all the indicator readings and provides a score ranging from +22 (strong inflationary pressures) to -22 (strong disinflationary pressures).  High inflationary pressures are signaled when the model rises to +6 or above.  Low inflationary pressures are indicated when the model falls to zero or less.

0203-13

Source: Ned Davis Research

Bonds, bond funds and bond ETFs lose money when rates rise.  I posted this next chart just a few days before Treasury yields hit a 35-year yield low of 1.37%.  What it shows is how much money is lost when rates rise.

If your starting point was a yield of 1.40% (top half of chart), as it was on 7/11/2016, and rates rose to 2.40% (which they did) your loss would be -8.84% if you were invested in 10-year Treasury Notes and -19.07% (bottom section of chart) if yields on the 30-year Treasury Bond rose to 3.25% (which it nearly did).  Further, note the risk of loss if the 10-year rises to 5.40%.  Note the -53.90% loss on the 30-year if yields rise to 6.25%.

0203-11

A number of pundits are calling for a 5% yield in the 10-year within a few short years.  I’m not in that camp but really… I don’t know.  I’m more in the “one more big recession” camp that will properly reset equity valuations and if so then rates should gap lower.

What I do believe is most important, is that investors should see this chart and size up the potential risk-reward for themselves.  With rates just coming off 5,000-year lows, my best advice is to think about your bond exposure as if your retirement wealth is dependent on it… and it is.

2.45% Treasury yields suck (as a good friend reminds me is a technical term) and rising inflation will eat into the net real yield and further cause interest rates to spike higher.  Treasury yields were north of 5% in 2007.

Be tactical with your bond exposure.  Don’t look at the last 35 years, as many people do, and project it forward.  The great bond bull market yield low is likely in.  Think differently about how you position that 40% of the traditional 60% equity / 40% bond portfolio.

The Bond Market is Facing a “Perfect Storm”

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I’ve been saying for some time that the biggest bubble of all bubbles is in the bond market. European sovereign debt might just be the first to crisis. Further, global debt has reached 325% of GDP. Academic studies show that economies get into trouble when debt-to-GDP exceeds 90%. Expand that to the U.S. and you’ll find a 105% debt-to-GDP number. (The number is actually much higher — 250% — if you include Social Security and Medicare debts.)

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According to Paul Schmelzing, “The current bond market is facing the “perfect storm” of potential steepening of the bond yield curve, monetary policy tightening and a multi-year period of sustained losses due to a “structural” return of inflation resembling that of 1967.”

Don’t despair… click below for ideas about what you can do with the fixed income portion of your portfolio.

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Real Implications of Reduced Pension Fund Returns

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pension_cartoon1Last week, the investment staff of CalPERS — the $300 billion California pension fund — announced that they want to reduce its target of 7.5 percent annual returns.  According to Chief Investment Officer Ted Eliopoulos, achieving a 7.5 percent annual return is no longer realistic.  Holy cow!

The implications of this proposal, if adopted, are significant and “would trigger more pain for cash-strapped cities across California and set an increasingly cautious tone for those who manage retirement assets around the country.”

Can you imagine how many people are going to be affected?  Here’s the bottom line.  The pension system, across our great nation, is underfunded and in trouble.

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Paul Tudor Jones’ 200-Day Moving Average Rule

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Paul Tudor Jones is one of the greatest traders of all time.  Jones’ firm, Tudor Investment Corporation, manages about $13 billion across multiple strategies.

Jones says, “The whole trick in investing is: ‘How do I keep from losing everything?’”  To which, he said he would advise investors to “to get out of anything that falls below the 200-day moving average.”  Visually, it looks something like this:

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Source: dshort.com.

Here’s a trend following idea for you to consider.  In the next chart, the black line is the simple 200-day moving average line.  The red dotted line is the 50-day shorter-term moving average line.  Both are a way of showing us the current price trend.  When the 50-day trend line moves above the longer 200-day trend line, the overall trend is bullish.  When below, it is bearish.

Since 1929, 65.98% of the time, the market trend was bullish and returns highest.  Likewise, the data since 2006 shows similar results.  The return figures are the percentage annualized gain per year.  The yellow highlight shows the regime we are in today.  The trend by this measure is currently bullish.

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Monthly Market Valuation Review

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11-04-09Early each month, we look at market valuations to see where we are.  It’s also important to consider what valuations may indicate with respect to probable (7- and 10-year) forward returns.   We believe risk is most when we feel it least and the risk is least when we feel it most.  Today, we feel it least.

In Friday’s On My Radar, we presented several valuation charts, including median price-to-earnings (P/E) and Warren Buffett’s favorite.

Bottom line: the market remains overvalued.  Trend following strategies can help you participate and protect.

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Dalio: Are We at the End of a Long-Term Debt Cycle?

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10-21-00Ray Dalio established Bridgewater Associates in 1975.  With $150 billion under management, Bridgewater is the largest hedge fund in the world.  The firm has approximately 350 institutional clients, including public and corporate pension funds, university endowments, charitable foundations, supranational agencies, sovereign wealth funds and central banks.

In 2015, Bridgewater published Economic Principles, a research paper discussing the driving forces behind the economy, and explains why economic cycles occur by breaking down concepts such as credit, interest rates, leveraging and deleveraging.  Here at CMG, our interns are required to read Economic Principles, among other books.  Though lengthy, it is the best working model on global economic cycles, debt, education, inflation and more I have read.

Dalio was interviewed by CNBC’s Andrew Ross Sorkin at last month’s CNBC Institutional Investors Delivering Alpha Conference.  In this week’s On My Radar, we summarize the interview and address Dalio’s question, “Are we at the end of a long-term debt cycle?”

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The Trend is Your Friend

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arrow-up-4Almost every effective strategy I know can be written on the back of a napkin.  The processes may appear to be simple, but implementation can to be complex and challenging.

My experience is that the best strategies can be explained simply.  The “trend is your friend,” as they say.  The hard part is having the emotional fortitude and discipline to stick to your process.

Why today?  71% of the world’s government bonds are yielding less than 1%.  Equity market valuations are too high.  Trend following strategies can help you participate in market advance and protect against major market declines.

Click below for an informative overview on trend following and research showing that the process can be effective over different periods of time.

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The Quest for Yield

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Yields are at 5,000-year lows.

71% of the world’s government bonds are yielding less than 1%.  33% yield less than 0%.  In a picture it looks like this:

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Source: Bloomberg; JPMorgan Asset Management, BofA Merrill Lynch

Risk is being overlooked in HY bonds.  Yields on high yield debt are close to the same yields on less risky loans.  The chase for yield has driven investors to riskier asset classes.

I am anticipating a once-in-a-generation buying opportunity in HY bonds.  While the trend this week is up, continue to invest with the trend.  Move to the safety of cash or Treasury Bills when the trend crosses down.

Click below for a great chart showing what a 1% increase in interest rates does to bond prices.  Show it to your clients!

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