WEEKLY ECONOMIC ANALYSIS: October 10th, 2009

Provided by TEAM Financial Services

"At twenty a man is full of fight and hope. He wants to reform the world. When he is seventy he still wants to reform the world, but he know he can't."
- Rodney Dangerfield

Items for discussion

While we covered this topic recently, we believe it is important enough to highlight once again. Bond mutual funds have seen an explosion in inflows from retail investors over the past year. The inflows have dwarfed the amount of assets that have flowed into stock mutual funds, despite the 50%+ recovery in the major stock market averages since the absolute March low.

For those readers who actually have a life and don’t follow such things closely, much of the bond market trades on what is known as a “spread basis”. Essentially, the value of a bond is gauged relative to what is considered a “risk free equivalent”. For example, company XYZ may issue a new 10 year bond and its spread to the 10 year US Treasury bond may be 2%. The current yield on the 10 year US Treasury is 3.384%, so a 2% spread would result in a yield of 5.384%. Many bond investors worry mostly about this RELATIVE spread far more than they worry about the ABSOLUTE yield of bonds. TEAM hopes most of our clients know by now that our primary obsession is focusing on absolute returns in general – i.e. whether the stock market is up or down 50% in any given year, our goal is to make reasonable positive returns. We view bonds through a similar “absolute return” lens.

The Federal Reserve has purchased well over ½ of the massive amount of US Treasury bonds issues in the past 3 months. TEAM is left to wonder where Treasury yields would be if this artificial demand was not in play. As we’ve chronicled in the past, the Fed is printing money out of thin air in order to monetize/buy these Treasury bonds. Would yields be .5% higher or 1% higher if this wasn’t occurring? We have no idea, but we suspect they would be higher.

In our opinion, those bond investors relying on spread relationships in order to invest may be making a terrible mistake. We believe there is a tremendous risk that US Treasury yields will head significantly higher over the next 3-5 years. We’ve identified a US “funding crisis” as the next potential crisis to face investors, and part of such a potential crisis would likely include significantly higher Treasury yields.

For anyone who has invested for more than the past 10 years, or at least is familiar with market history (yes I admit to being in my mid 30’s!), a 10 year Treasury yield of 7-8% would be considered reasonable. Many may remember when yields were in the mid double digits in the early 1980’s. My colleague, Sam Lindenberg, is fond of telling the story about his 15% mortgage when he bought his house when he moved to Central PA (much like the old “I walked to school in 3 feet of snow stories” some of our seasoned citizens share!). Money market rates have commonly been in the 4-6% range over time.

Many bond investors appear willing to lock up money for 10 years at mid single digit returns and justify it because they are getting an “adequate” risk spread over US Treasuries. TEAM has seen this game before on several occasions. Relativism can be a very dangerous practice as an investor. There were dot com stocks in 1999 that were “cheap” relative to other dot com stocks. There were Las Vegas condos that were “cheap” relative to other Vegas condos in 2006.

One of the most pernicious and morally reprehensible components of our government’s current policy is what it is doing to otherwise conservative savers who are now being “forced” to take risk. We witnessed this with horror during the 2003-2007 period as many seniors rushed into bank preferred stocks and other vehicles that subsequently "blew up". A senior living off of a 10 year CD that may have been at 6% may be finding out that a comparable CD may only yield 3% today. In a quest to preserve their income for such gratuitous items such as medications, food and shelter, is it any wonder why someone in that situation may be willing to move out the risk curve to try and preserve that level of income? Why not buy a “conservative” bond mutual fund that yields around 5%?

Despite all of the crazy market developments since 2000, investors haven’t faced a good old fashioned bond bear market in a long time. There was a relatively brief flirtation with one in 1994 before Alan Greenspan folded (as he always did) to the Wall Street bond traders screaming for mercy. Prior to that time, it has been since the late 1970’s and early 1980’s that bond traders/investors have had to deal with persistently higher interest rates. While mob rule can get one run over if one tries to stand in the way of the stampede, they almost always end badly. We don’t yet have a good feeling as to when the current stampede may end. However, just as prior stampedes have left the masses with deep regrets (rushing into tech stocks in 1999 or flipping houses in 2007), rushing into bonds at the moment is likely to be bad for one’s financial health over the long run. We suspect those rationalizing bond purchases using relative metrics will eventually learn the expensive lesson of absolute value.

Market/Economic Climate

While the stock market remained extremely, and impressively, resilient this past week, there is some movement in the quicksand that lay in the foundation. The US dollar index reached a downside target in our model and bounced significantly off the lows late in the week. It has been very unusual for stocks to ignore a rally in the US dollar, yet that is precisely what occurred on Friday. The US Treasury market also reversed sharply on Friday, as bond prices dropped and yields rose. The synchronized trend in recent weeks has been stocks/commodities/bonds rallying as the US dollar drops. Friday was the first day in which these correlations broke down. The US dollar rallied with commodities and bonds falling. As mentioned, stocks defied the dollar rally and diverged.

Of course, this is just one day, but given the proximity of the major stock market averages to one of our longer term target areas, next week is likely shaping up to be very important to TEAM as to how we adjust client portfolios. At present, client portfolios remain positively exposed to stocks and commodities, but at a dramatically lowered level due to extensive portfolio hedges. This is due to our research and model indicating that there is a high probability that the US dollar is poised to enjoy at least a multi-week rally and that stocks will eventually relent and correct in price at the same time. Our current allocation should be fairly well positioned to weather such a scenario. Importantly, should things not develop as we expect, then we may need to swiftly shift portfolio exposure and scale back some of our hedges.

We recognize this kind of account activity can be unnerving to many clients, but it is a critical part of our flexible strategy that has enabled us to provide consistent absolute returns over time. As always, we are happy to address any client questions or concerns regarding portfolio holdings or activity.

Humor for the Weekend (From last week)

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.