Bond market in focus

Most stock investors, myself included, tend to focus solely on how the stock market is doing. I own almost entirely stocks and so do my clients, so why focus on bond markets?

For starters, bonds are alternatives to stocks. If bond yields rise high enough, some people will sell stocks to buy bonds. If bond yields are climbing, like they have been lately, then it may lead investors to sell stocks and buy bonds.

Bonds are also a strong indicator of inflation. If bond yields are climbing, it means bond investors are probably worried about inflation. With governments around the world printing money to get the world economy going again, this worry is not unjustified. Inflation is bad for stocks in the short run, so increasing bond yields are a bad sign for stocks in the short run. If you remember the 20% stock market crash that happened in one day in 1987, you might also like to know that bond yields had been rising and the dollar sinking for months beforehand. Sounds like today in some ways…

Bond markets are good indicators of financial stress, too. When investors become worried about credit issues, they frequently flood into U.S. Treasuries, which leads to declining interest rates. Lately, interest rates have been going the other direction, indicating that worries about credit issues are declining and the economy may be recovering. This could be signaling the end of the credit crisis, and/or the beginning of a dollar crisis.

Bond markets are as vital to understanding the economy and investing as stock markets. They frequently signal economic, credit, and inflation changes long before stock markets do. It’s important to pay attention to bond markets for this reason.

As I’ve highlighted above, interest rates have been climbing recently. Interest rates climb when bond prices go down, and are an indication that stock markets may decline because of competition with bonds or worries about inflation. Increasing interest rates can also mean the credit crisis may be ending, the economy may be improving, and investors may becoming increasingly concerned about the value of the U.S. dollar.

These are important things to consider.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Selling low and buying high

Sometimes the stock market seems like a machine designed to produce regret.

When the market goes down, most people hang on until they reach a point of maximum pain and they sell. That’s when the market starts to climb back up again.

When the market goes back up, most people wait for the market to pull back (so they can “buy back in”). When the pull back doesn’t occur and the market continues to climb, they reach a point of maximum regret and buy back in. That’s when the market starts to tank again.

And so the story goes on and on over time. People end up buying at the top and selling at the bottom, en masse, because they invest using their psychological inclinations instead of their heads. That’s what allows calmer minds to make money over time.

The financial press is full of articles about those who sold at the bottom and are now regretting it and buying back in at the top. Why don’t people learn that trying to time the market doesn’t work?

This fear and regret cycle has repeated twice over the last 6 months. As the market tanked in October and November of last year, people sold at the bottom. As the market climbed out of those lows, the same people bought back in only to see the market tank again in March. Guess what happened from March to May? Rinse and repeat.

Why don’t people just accept that their psychological inclinations are almost always wrong when it comes to investing in the stock market? I don’t know. Tons of studies have shown that people make bad investing decisions using their psychological reactions. And yet they continue to do so.

The stock market will go up and down, I guarantee it. When it feels awful to hold on, you should be buying. When it feels wonderful because things are going up, you should be selling. Do almost the exact opposite of what you feel, and you’ll be a better, more successful investor.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

A little extra cash is not a bad thing

I must admit, I used the recent stock market rally to sell some of my clients’ and my holdings, and I didn’t re-invest the money into something else right away.

This may sound like a prudent thing to do, but many take issue with such an approach.

They believe not being fully invested means timing the market. But I disagree with the approach that always being fully invested is the smartest way to go. I also disagree that not being fully invested–holding cash–means timing the market.

In the history of free enterprise, the most successful businesses almost always operate more conservatively than they need to. By doing so, they have the ability to be aggressive in difficult times.

During the Great Depression, companies with extra cash were able to boost advertising at low rates, purchase competitors at cheap prices, expand into new markets, etc., while their competitors were simply attempting to survive the crisis. Having extra cash on hand during tough times allows great businesses to buy at super-cheap prices exactly when competitors are hamstrung.

The same is true for investing. By operating a bit more conservatively–holding extra cash in principle–an investor can purchase during those rare times when prices are once-in-a-lifetime cheap. Those who are fully invested cannot. Those with extra cash may under-perform during boom times, but they tend to out-perform over the long run.

Holding extra cash is not the same as timing the market, either.

Timing the market is the attempt to sell at the top and buy at the bottom. That’s not my approach, nor do I think timing the market is a successful strategy.

Instead, I assess the value of businesses. With such an assessment, I attempt to purchase businesses (that’s what buying stock is: purchasing part-ownership in businesses) when they are cheap and sell them when they’re dear. The buying and selling occurs because of the relationship of price to value, not because of my opinion about the market’s top or bottom.

Carrying extra cash can be a competitive advantage, both in business and investing. I’m happy to sit on a little extra cash and wait for stock prices to move to cheaper valuations. If it happens sooner, great. If later, that’ll work, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

It looks like a slow economic recovery is on the way! (but that doesn’t necessarily mean we’re out of the woods)

At long last, there are some pretty solid signs the economy may recover soon.

This week, both the weekly initial jobless claims report and the monthly unemployment report showed improvement. Initial jobless claims have been high, but declining, which usually happens several months before the economy starts growing again. The monthly unemployment report showed high and growing unemployment, but with much fewer jobs being cut by employers.

These reports aren’t saying the employment situation is getting better, just that it’s getting bad less quickly. But, that’s always the first necessary step to an economic recovery.

You see, unemployment almost always peaks long after the economy starts growing again, so it’s normal for the employment situation to be getting less bad when the economy turns.

Not surprisingly, the stock market anticipated this situation. The market has been rallying since March, showing once again its predictive ability. But keep in mind, the stock market has forecast 9 of the last 5 recessions and 9 of the last 5 recoveries.

That’s not a typo, the stock market frequently tanks or moves up falsely, indicating things are getting worse or improving when that isn’t the case. In other words, it’s not a great indicator by itself, but it is a good indicator in concert with others.

Adding to information from employment and the stock market, the Chinese government is working hard to stimulate its economy, and it looks like those efforts have been successful so far. Unlike the U.S. government, the Chinese government actually has money to stimulate their economy instead of simply borrowing from others to stimulate. This doesn’t mean the Chinese government’s efforts are efficient or even sustainable over the long run, but for now it’s working, and they have a lot of money they can spend to get things going.

Putting these data points together, along with retail sales, copper prices, industrial activity, inventory levels, and so forth, it looks like an economic recovery is on the way.

How will this impact investors? Good question. As usual, I don’t really know what will happen in the short run.

This could be a V recovery, a sharp economic rebound, a U recovery, a long slow period followed by faster growth, a W recovery, a sharp rebound followed by another slowdown followed by a sustainable recovery, or an L “recovery,” where we don’t really recover so much as things don’t continue getting worse. An L recover is really a U recovery where the base of the U is very, very wide. Think Japan over the last…well…20 years.

If a V recovery is in the works, the stock market could just keep going up. It won’t move straight up, because conflicting information will cause temporary setbacks, but on the whole it will not reach new bottoms and will trend upward over time. That would be the most fun, but I believe it’s the least likely scenario. It’s possible, though.

A U or L recovery would mean the stock market has gotten ahead of itself, and if companies start pre-announcing that things don’t look that great for the 3rd and 4th quarter, the market would probably tank. The market’s recent move indicates V or W with strong growth and earnings beginning late this year or early next. If that doesn’t happen, market participants will be very disappointed and prices will decline, perhaps significantly.

If a W recovery is in the works, the market could go up for the next year or more, only to crash again as the current nascent recovery turns out to be a false dawn followed by another recession. Unfortunately, I see this scenario as quite likely. Government stimulus may lead to higher inflation and high commodity prices, which could send the economy right back into recession.

My guess, and I’ll admit its no better than that, is that we are in a W recovery. That means enjoy the rally for the time being, but be prepared for another downdraft in a year or two. This may sound unpleasant, but it will produce many opportunities to make money both on the up and the downside. That’s what happened in the late 1970’s and early 1980’s. There was a lot of money to be made on commodities during the turmoil, and then the greatest bull market of all time began in 1982.

The next most likely scenario, in my opinion, is a U/L recovery. This would be no fun for most investors, but work out fine–over the long run–for the prepared. It would provide a lot of false dawn rallies and several exploitable downdrafts. That’s what the 1930’s and 1970’s looked like, as well as Japan over the last 20 years.

The V recovery, which I consider least likely, would, I believe, look like the recoveries we saw after the late 1990-91 recession and the 2001 recession. In both cases, the market didn’t really take off until a couple of years after the economy left recession. In both cases, they were referred to as “job-less” recoveries, with economic growth and very slow employment improvement.

As you may have noticed, I didn’t include any scenario where the market just takes off into a 20 year bull market with annualized returns of 20%. That’s because I consider such a scenario so unlikely as to be hardly worth mentioning. It’s possible, but I wouldn’t bet on it.

It feels a lot better to be talking about recovery than it did talking about how bad things were last November or March. However, I believe the market may be getting ahead of itself in predicting robust growth by year end. It might be a good time to take some profits and sit on a little bit extra cash.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The peril of bonds

Long term bonds have beaten stocks for decades.

As reported by Rob Arnott (chairman of Research Affiliates), 20 year bonds have provided better returns than the S&P 500 starting any time from the 1979 through 2008.

That’s a startling fact to many investors who’ve been told, ad nauseam, that stocks always do better than bonds over the long run.

This out-performance by bonds has not gone unnoticed by investors, who are selling stock mutual funds and buying bond funds.

Is it time to abandon stocks and buy bonds?

No.

You shouldn’t drive your car by looking in the rear view mirror, and you shouldn’t invest your money that way, either. The past can be a wonderful guide to the future, if and only if situations are sufficiently similar.

But, the situation over the next 30 years is highly unlikely to be the same as it was over the last 30 years.

For starters, inflation was in double digits 30 years ago. When inflation is high, bonds sell at super-cheap prices. When high inflation is tackled, as it was by Paul Volcker in the 1980’s, and continues to decline for another 20 years, as it did, then bonds have remarkable performance.

That is not the situation today. In fact, reported inflation is at an all time low, showing its first annual decline since the mid 1950’s. Bond yields reflect this low inflation with record low yields.

Bonds will not perform as they did over the last 30 years because inflation isn’t starting high and going to record lows. Count on it.

In addition, the threat of growing inflation is as high now as it was the last time bond rates were this low, in the 1960’s.

At that point in time, government spending was going through the roof to fund new social programs like Medicare and to fight an on-going war in Vietnam. If that sounds familiar to you, it should.

The U.S. government is running record high deficits as a percentage of the economy in an attempt to jump start an economic recovery, fight on-going wars in Iraq and Afghanistan, fund social programs like universal health care, and reduce carbon emissions to prevent global warming. If you think that won’t sooner or later lead to high inflation, I’ve got a few bridges I’d like to sell you.

Just because long bonds have done well in the past doesn’t mean they will do well in the future. If deflation continues for some time, as many smart people think it will, long bonds will do well. But, I believe that situation will only be temporary.

When inflation kicks up, as I think it will, long bonds will be gutted.

Stocks may not do well in the short run, but they offer excellent long term protection against inflation. Stocks are also selling at historically low prices relative to bonds. Bonds are now priced for perfection (low or declining inflation) whereas stocks are priced for a sustained recession.

Stocks may under-perform bonds over the short run, but over the long run, I don’t think its even a contest–stocks will almost certainly out-perform over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.