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.

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Will the Fed cut rates?

The market certainly seems to think so.

Just look at interest rate futures and you’ll see investors are expecting a 25 to 50 basis point cut in the Fed Funds Rate.

Or, more meaningfully, look at the gold market. Gold prices spiked to over $785 an ounce, today.

That’s up 17% over the last month and 31% over the last year.

Why does the gold market indicate a cut in the Fed Funds Rate?

Because the Fed does not create growth–they do not possess some magical fairy dust that makes the economy run faster.

The Fed prints money to decrease interest rates. And, when the Fed prints money more quickly than the economy grows, they create inflation.

Gold prices are going up because gold investors believe the Fed will print money, also known as cutting the Fed Funds rate, thus creating inflation.

Gold is going up because investors are guessing the Fed will create inflation by cutting rates.

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.

Did credit market turmoil rattle equity markets…again?!

I watched with fascination as short term government interest rates plunged on Wednesday and Thursday. But, to my surprise, equity markets barely reacted.

Then along came Friday.

I don’t think the anniversary of the 1987 stock market crash had a thing to do with it, but I do think interest rates had something to do with it–like they did in 1987.

When I see short term Treasuries surging in price and their yields plunging, that means that someone, somewhere is scared and they are running to the safest securities they can find–US Treasury securities of short duration.

Whenever this happens, like it did in August, it means risk is becoming more expensive. And, when that happens, equities will almost always dive.

Why did it take a couple of days to work out? I don’t really know.

Perhaps the same people running to safety were hoping things would cool off, but they didn’t. And when risk continued to be more expensive, then they started selling equities.

Perhaps some leveraged investors, like hedge funds, were squeezed by the people who lent them money as credit markets seized up again.

Who knows?

But, I do know you could see it coming, and it didn’t surprise me (except that it took so long).

Its amazing to watch this because it shows how integrated financial markets are.

Anyone watching short rates plunge on Wednesday and Thursday had to scratch their head and wonder why equities weren’t tanking. That is, until Friday–when they did.

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.

If a shoe falls in the woods, and no one is around to hear it, does it make a sound?

In an earlier post, I brought up what could knock down credit markets. One issue was the availability of credit, which has been the subject of much pain and anguish, recently. The other two issues were interest rates and employment.

In the news today, the employment report for the month of August looked dreadful. For the first time in 4 years (when we were stumbling out of the last recession), payrolls tracked by the Labor Department shrank instead of climbing.

Could this be the result of financial service firms laying off workers in an attempt to adapt to current credit conditions? Could these laid off workers then have trouble making their home payments, thus promoting the negative spiral of home price declines, credit defaults, financial market troubles, and more layoffs?

I certainly think so. In fact, I believe this is the beginning of the other shoe dropping. I also believe the Fed will react as it always does, by lowering interest rates in an attempt to “jump-start” the economy.

This will, in time, lead to higher interest rates on longer dated bonds as foreigners demand higher rates to compensate for the dropping dollar. The dollar will drop further as more and more market participants realize the Fed will lower interest rates by printing more dollars (in other words, creating inflation).

How bad will this get? I don’t know, but lower employment and higher interest rates will make current housing problems look tame by comparison.

It’s a good time to avoid companies with lots of debt. It’s a good time to avoid investments related to the housing market or its financing (although a bit late).

More importantly, it’s a good time to be invested in securities that will benefit from this fallout. It’s a good time to have some cash that can be invested as the market goes down.

If inflation is a concern, it’s a good time to consider investing in tangible things (other than real estate) that are hedges against inflation. It’s not a bad time to consider foreign investments that may be hedges against inflation, too.

It’s also a great time to consider those companies that will fair best as we emerge from our credit market problems and into another growth up cycle.

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.

Bill Gross’s Investment Outlook

Bill Gross is a legend in the investing industry. He doesn’t work, though, in the more glamorous equity side of investing. Instead, he is a bond market investor, and has one of the best long term records in the business.

Gross also happens to be an outstanding writer. I envy his ability to say a lot with few words, and to explain complex financial concepts with amusing analogies.

For these reasons, his monthly Investment Outlook is a must read for me. As usual, his Investment Outlook for this month didn’t disappoint.

Gross takes to task the mortgage market, how it has performed and will perform in the future. His conclusion is that the fallout is not over, and that we’re just looking at the tip of the mortgage iceberg.

He believes this is the case because many adjustable rate loans made over the last several years have yet to reset, and when they do, many more homeowners will punt their houses back to the market.

He also indicates that these problems will be felt in the Mortgage Backed Security (MBS) and Collaterlized Debt Obligation (CDO) markets. This, along with legislative action, will tighten credit and limit the number of people who can get new loans.

His conclusion is that the housing market will takes years to work through it’s problems (tougher credit, high inventories of homes for sale, anchoring by home sellers), and that the Federal Reserve may soon cut rates in an attempt to limit such problems now that inflation is looking less threatening (according to their narrow metrics).

Am I planning on acting on this advice? I can’t say I am. Unlike a bond market guru with institutional clients who demand short term performance, I don’t need to forecast interest rates or try to guess what the housing market will do. But, I find his thinking very provocative, and it reinforces my desire to stay far away from companies that deal intimately with the housing or mortgage market.

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.

Interest rates

For those of you not paying attention, the bond market has had an amazing month and a half!

If you are thinking to yourself, “What does the bond market have to do with anything, I buy stocks,” hold on to your hat.

Bonds are frequently used as the discount rate or the base rate from which discount rates on stocks are computed. This is most prevalently seen in the Fed Model, but is also the way almost every finance textbook used in business school starts.

If bonds drop in price, and their yields go up (as has happened lately), then stock prices should go down (all things being equal, and they never are). By how much? I’ll get to that below.

Back on May 2nd, the 10 year yield on US Treasury bonds was 4.64% and the 3 month yield on US Treasury bills was 4.87% (according to Value Line’s May 11 Selection and Opinion). Today, according to PIMCO’s website, the 10 year is yielding 5.30% and the 3 month is yielding 4.72%.

This is a massive change! The 10 year’s yield jumped 0.66% and the 3 month’s yield dove 0.15%. Because the bond market has such a huge impact on all discount rates in the market, this is a huge change!

For those of you thinking the stock market’s recent sell off has taken account of such a discount rate change, think again. The DJIA was at $13,211.88 on May 2nd and closed at $13,295.01 today, a 0.63% increase. All things being equal (assuming estimates on company earnings haven’t changed), the DJIA should be at $11,566.60–down 12.45%! Instead, it’s at $13,295.01, implying that earnings estimates for the DJIA have increased by 14.95% in the past month? I doubt that.

I’m NOT suggesting the Fed Model is correct or that stock prices should move precisely with bond yields, but I am suggesting that the stock market, and perhaps other markets, have not taken full account of recent bond price and yield movements.

Also, how do you think bond price moves will impact mortgage and housing markets? A 30 year mortgage on a $300,000 house should go up around 7% per month (or $130) based on this bond price change. Does it seem like that’s been figured into market prices for home builders and mortgage companies? It doesn’t seem like it to me.

As usual, I’m making no assumptions about what will happen in the market and when, but I do find recent bond market moves disturbing.

Perhaps bond prices and yields will go back to where they were, vindicating recent stock market moves. Perhaps fundamentals are improving just as quickly as bond prices are dropping and this justifies no move in prices.

I can’t predict what will happen much better than the next guy, but I am scratching my head and wondering what other people in the market are thinking.

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.

Dow 13,333

Amazingly enough, the market just keeps hitting new highs.

Despite headwinds from a slowing economy, higher gas prices, and a rocky housing market, most companies beat analysts estimates for the quarter.

The world economy is thriving with good (for them) growth rates in Europe and very high growth in China and India.

U.S. companies benefited this quarter, too, partially because they sell many goods and services to other countries and partially because the declining dollar provided an additional tailwind to results.

Another benefit, which the analysts seemed to have missed, came from companies buying back their own stock. If a company’s earnings increase by 5% and it buys back 5% of its stock, it suddenly has 10.5% growth in earnings per share. No real magic there.

I’m not foolish enough to try to forecast the short term direction of the market, but I do have some questions about how these dynamics will affect markets in the future.

If the Chinese economy slows, as the government there is trying to make happen, how will that impact the world economy? How much further can the dollar decline before it leads to increases in U.S. interest rates? How could U.S. companies be impacted by a slower world economy and higher U.S. interest rates? How much longer can companies buy back their shares instead of investing in new projects, capital expenditures or wages and salaries?

I don’t claim to know the answer to any of these questions, nor do I believe that answers to these questions are necessary to successfully invest over the long term. But, I do think it is important to assess the substance behind the recent good news and ask myself whether such tailwinds are likely to continue going forward.

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.