Category Archives: Strategy

Bond Environment, 2Q12 (i)

April 26, 2012 By in Bond Environment, Current Market Thoughts, economics, employment, Portfolio management, Strategy Tags: , , , , , , , , , , Leave a comment
Here’s the first part (of two) of the April bond market analysis prepared for clients by the firm of my friend and mentor, Denis Jamison.  The second will appear tomorrow.
The alarm clock sounded for bond investors in the March quarter.
On the strength of some positive readings on the economy, markets discounted the possibility of additional Federal Reserve easing.  More accommodative policies by the European central bank reduced the risk of a credit crisis in Spain and Italy. Accordingly, doomsday speculators pulled money from the U.S. government bond market. The result was a dip in bond prices. With little coupon income to cushion the fall, investors suffered big losses.
Long term U.S. Treasury bonds recorded a negative 6% total return. Other sectors fared better; mortgages returned about 0.6% for the quarter while corporate bonds gained about 2.5%. The investment dynamics of these sectors differ somewhat from those of the government bond market. Mortgages are big beneficiaries of the Fed’s zero short-term interest rate policy while corporate securities are helped by the improving financial strength of U.S. business, especially the banks. Yield spreads between corporate bonds and U.S. Treasuries narrowed sharply during the quarter. Whether this can continue, remains to be seen.
Bond prices snapped back sharply after a ho-hum employment reading for March (reported on April 6th)
…and on renewed concerns about Spain’s fiscal position. However, investor focus on these transient economic and credit risk factors obscures the underlying reality of the government bond market. The current low yield level has made these securities more risky. Their price sensitivity to any given change in interest rates has increased. For example, a full coupon thirty year bond priced to yield 3% is about 10% more volatile than a similar full coupon security priced to yield 4%. In addition, there is significantly less coupon income now than in prior periods.
The fixed income markets are anesthetized by a cocktail of promised zero short-term interest rates, a flood of liquidity being provided by central banks around the world and quiescent inflation.  So, it is likely we will continue along the bottom of this interest rate trough for some time.  That doesn’t mean, however, that the bumps and dips won’t provide large swings in total returns for bond holders.
Back on track?
For the U.S. economy, that’s probably true. Despite disappointment regarding the March employment numbers, by any reasonable measure, the U.S. economic expansion is where it should be. Based on the March workplace survey by the U.S. Labor Department, about 132.8 million folks are employed versus 130 million a year ago. That’s a 2.1% year on year gain. A respectable increase considering that the public sector – particularly state and local governments – reduced payrolls. Only 22 million people worked in the public sector in March – 600,000 less than a year ago. In addition to the increase in total workforce, those employed are taking home more money. Average weekly earnings are up about 2.6% over the last twelve months.
Thanks to the employment gains and higher earnings,
retail sales have fully recovered from the recession lows.  They are running ahead 6.5% on a year over year basis. Auto sales are now averaging between 14 and 15 million units on an annualized basis compared with less than 10 million units during much of 2009.  GDP – the broad measure of total goods and services being produced in the U.S. economy – grew at a 3% rate during the final quarter of 2011. While that pace of expansion is unlikely to be sustained, it is reasonable to expect growth will exceed the 1.6% pace set during the full year of 2011. Most economists predict something between 2% and 2.5% growth this year.
Most of the risks to this moderate expansion scenario don’t hold up well under close examination.
Some argue that the recent growth spurt is being fueled by the large increase in reported consumer debt – consumer credit expanded 6.9% in the final months of 2011. However, most of that increase reflected an expansion of government education loan programs which replaced private sector programs that were not included in the consumer credit totals. Basically, the consumer is not overextended. Gasoline prices are also a concern to many. However, auto fuel efficiency has increased and gasoline usage is down. Price changes at the pump will have a much more muted impact on consumer spending. Given this backdrop, it isn’t surprising that many Fed governors are beginning to question the need for a continuation of the current monetary stimuli being provided by the central bank. However, financial markets now appear to be addicted to these opiates. This may be the real risk facing both investors and the working public.
Stay tuned for the concluding section of the Jamison report tomorrow.

cascades of economic energy and finding a stock-picking focus

April 20, 2012 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Strategy Tags: , , , , , , , Leave a comment

finding the focus

One of the most creative (and successful) investors I’ve ever encountered–and, luckily for me, one of my earliest mentors–gave me this example of his investment style:

Suppose, he said, Washington has decided to stimulate the economy and we’re in the early days of a nationwide road building boom.  What stocks do you buy?

–Your first inclination is to look at construction companies.  That’s what most people buy.  But they’re usually conglomerates, with significant non-public works subsidiaries. There are also lots of them.   It’s difficult to predict who will get contracts and how profitable they will be.

–Your next thought is probably construction materials, like cement or asphalt.  Certainly, roadbuilding will require lots of that stuff.  But the same problem arises here, on a smaller scale–determining who, among many possible suppliers, gets the contracts and how important they are for the overall profits.  One extra quirk:  the low value-added nature of construction materials and their high weight (meaning big transportation costs) make individual plant locations crucial.  Figuring that out is especially hard.

My friend’s answer?  …cement trucks.  Buy stock in the one or two companies whose main business is making cement trucks.  No matter who gets the government construction contracts, no matter which suppliers they choose, they’ll need to transport cement to the construction sites.  As orders build, they’ll have to upgrade their truck fleets.  Large-scale contracts also mean large-scale upgrades.  That’s where the economic energy from the government road building program is going to be focused.

cascades of energy…

This is absolutely right, in my opinion.  It’s Levy Strauss selling blue jeans to Gold Rush miners all over again.

To recap, the surest and safest way to play any economic phenomenon is to find, if you can:

–the sole supplier

–of an essential component

–whose price makes up a very small cost in the creation of the ultimate end product made or sold.

This most likely means that buyers of the component will be much more concerned with the quality of the component than the price.  So the component maker should be able to make unusually high profits.

In my experience, I’ve found there’s also another–time-related– aspect to investor behavior in playing any powerful source of economic energy.

Institutional investors typically proceed as follows:

–initially they tend to buy largest-cap and most obvious ways to play whatever the theme is.  In the context of my friend’s road example above, they buy the general construction companies.

–after the prices of these stocks have gone up for a while, the big investors’ attention begins to move to the most obvious derivative plays–the cement companies–and buy them.

–ultimately they “discover” the cement truck companies and add them to their portfolios as well.

If you know the industries involved well enough, you can see a cascade of successive waves of investment that chronicles the travels of the consensus deeper and deeper into the derivative plays.

…forming a timeline

This changing, and ever narrowing, focus of big investors typically forms a timeline that we can use to judge how much energy remains in a given economic phenomenon in stock market terms.  Once the big guys work their way to the metaphorical cement trucks, that signals most of the money from the theme has already been made.

At this point, the market either goes back to the start of all the excitement–the general construction companies–and begins the cascade process all over again.  More commonly, the market moves on to other areas.

where are we now?

Although it’s relatively early in the 1Q12 earnings season, I’m struck by two characteristics of the market reaction to earnings announcements so far.

The first is that positive reaction is highly company-specific and relatively narrowly focused in the sense I’ve been writing about.  To me, this means that before long the market will no longer be following ever more indirect ways to play the fact of economic recovery from the Great Recession.  It will be looking for new areas of interest instead.

I’ve also noticed that my portfolio, which is more of the cement truck type–and which had been in the dumps for the past several months–is beginning to perk up again.  Yes, my stocks have had an extraordinary two years or so before starting to fade away, but that’s the past and not relevant for today.  I’m also reading my recent outperformance as evidence of an ongoing maturing–maybe even an upcoming sea change–in stock market focus.   More about this in my next Current Market Tactics, on Monday.

 

what are bond vigilantes? …are they making a comeback?

April 12, 2012 By in bond vigilantes, Portfolio management, securities markets, Strategy Tags: , , , , , , , , , , 2 Comments

vigilantes…

Vigilantes were members of 19th century American “vigilance committees,” composed of citizens who banded together to render immediate, and often rough, justice in circumstances where they felt formal law enforcement actions were insufficient.  Whether this was a good thing or not, I don’t know.  But the idea of vigilantes has become part of American folklore.

…and bond vigilantes

I first saw the term “bond vigilantes” in the 1980s in the work of brokerage house economist Ed Yardeni.  My impression is that he invented it   …but, hey, I’m a stock guy not a bond expert.  The idea was that should the Fed falter, due to political pressure, in its mandate to contain inflation under Paul Volcker (as it had throughout the 1970s, under his predecessors), private bond investors would step into the Treasury market and tighten money policy (by pushing up bond yields) whether the Fed liked it or not.

The concept later morphed into the idea that private bond investors would routinely raise and lower bond prices, and thereby interest rates, in the way sound money policy would dictate.  The market would act in advance of formal Fed moves.  Fed actions wouldn’t normally break new ground, but would serve to validate the direction the market was already taking.  This supposedly took some political heat away from the Fed during the long and difficult road of containing the runaway inflation of the Seventies.

Like most generalizations from current experience, the bond vigilante idea worked for a while.  But it has long since lost its usefulness.  For one thing, China became a huge factor in the US bond market as it recycled its trade surpluses.  And Alan Greenspan gradually developed a penchant for smoothing every little bump in the economic road with another huge dollop of easy money.  Ironically, one of the “problems” he dealt with in this manner was the Y2K scare–popularized almost single-handedly by the same Ed Yardeni.

(If you recall, the thesis was that, due to a programming shortcut, every electronic device that contained a computer chip with a clock in it would stop working at the stroke of midnight on 12/12/1999.  That meant refrigerators, elevators, ATMs, PCs…everything.  Software of all types would go kablooey, as well.  So bank and medical records would likely disappear.  During 1999, survivalists were in their glory.  They stockpiled horse-drawn plows–inconveniencing the Amish considerably–and gold and silver coins.  Regular people stockpiled water and gasoline (because pumps might not work, either.

It’s hard to know–since none of the bad stuff happened–whether Yardeni was a hero for alerting the world in time to avert the worst, or just a little nuts.  But he certainly gave Greenspan an excuse for maintaining an easy money policy.)

why the trip down memory lane?

I think I saw the activity of bond vigilantes in trading during the first quarter of this year.  The 30-year yield moved up from 2.94% in December 2011 to 3.33% last week.  The 10-year yield went from 1.94% to 2.21% over the same span.  This, despite Ben Bernanke’s continual assertion that the Fed intends to keep interest rates low through this year and next.

Of course, yields have reversed themselves sharply in the current mini-panic over the latest Employment Situation report and the uptick in southern EU bond yields.  But I read this more as a ripple caused by short-term traders than anything else.

And why shouldn’t the bond vigilantes re-appear?  After all, Mr. Greenspan no longer has his hand on the money spigot.  And China is much less of a net buying force in Treasuries than in the past.

Significance?  We may be seeing the first steps in the normalization of interest rates–far in advance of when the Fed wishes.  Two implications, assuming the markets are correct:

–the US economy is in better shape than the consensus realizes, and

–a sharp divergence in performance between stocks and bonds–in favor of the former (previously, I’d made a typo here)–may be about to begin.

The March 2012 Employment Situation report: hiring slowdown?

April 9, 2012 By in economics, employment, Employment Situation report, Recent Market Action, Strategy Tags: , , , , , , Leave a comment

the report

The Bureau of Labor Statistics of the Labor Department released its March 2012 Employment Situation report last Friday, while virtually all the stock markets of the world were closed for Good Friday.  The US bond and derivative markets weren’t, however, and both reacted to the news.

The report said the US economy added 120,000 jobs during the month–about half the gains posted in each of the prior three.   The main areas of difference were in:  temporary help, which recorded 54,900 new positions in February and a loss of -7,500 in March; and in healthcare, which added 26,100 jobs in March vs. 52,800 in February.

revisions weren’t any help, either

February job additions, in their first of two monthly revisions, went up from 227,000 new positions to 240,000.  January additions, first reported at +243,000 and revised up last month to +284,000, were revised down in the March report to +275,000.   So net upward revisions of past months totaled only +4,000 extra jobs.

market reaction was swift, and negative

S&P 500 stock index futures dropped a bit more than 1% last Friday.  Government bond prices regains much of the ground they had been losing over the past month.

Two reasons for the reaction:  the March BLS figures showed only about half the gains of the prior three months, casting doubt on investor belief that economic growth in the US had reached a permanently stronger stage of recovery;  also, the March job additions are at or below the level needed to absorb new entrants into the workforce, so they do nothing to help reduce the number of unemployed.

what significance do one month’s figures have?

Not a lot.  Last August’s Employment Situation, for example, initially showed zero job growth in the economy–a figure subsequently revised up to +104,000 new positions.

Currently, other indicators–like consumer confidence and retail sales–have been rising, adding support to the idea that the strong ES figures from December-February are valid signs of an improving domestic economy and broadening economic recovery.  The evidence I’ve seen from individual company reports tends to support this view.  And the ADP employment report last Wednesday, quirky as it may be, showed +209,000 new jobs.

But, I think, the market has maintained an underlying suspicion that somehow the mild winter in the most heavily populated parts of the US has messed up the BLS’s seasonal adjustment mechanism,  and that, as a result, the apparent economic strength is just work that usually must wait until March or April being done in January of February.  So it’s very willing to believe the December-February ES reports overstate the job situation.  On this view, March is just a return to reality.

my thoughts

I don’t think the current ES report is enough evidence to warrant changing an equity portfolio orientation away from the idea that 2012 will be a year of broadening recovery.  We need more evidence.

If seasonal adjustment factors are responsible for skewing the ES numbers, it’s possible that March is the victim–not Dec-Feb.

The S&P 500 has moved up so sharply so far in 2012 that backing and filling for a while wouldn’t be surprising.

Stock price movements today will be interesting to analyze–especially to find economically sensitive stocks that outperform the market.

Typically, a strong economy with rising interest rates means weak bonds but a flat to up stock market.  Will this rule of thumb hold in 2012?   …by showing the other side of the coin, today may provide a valuable clue.

 

 

 

 

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