Category Archives: Shaping a portfolio for 2012

prospects for fixed income in 2012 (III): conclusions

January 19, 2012 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Recent Market Action, Shaping a portfolio for 2012, Strategy Tags: , , , , , , , , , , , , Leave a comment

This is the final installment of three that contain a bond market analysis by money manager Strategy Asset Management, LLC.  (Installment I, Installment II)

Risk and Return

Bond investors will face some difficult choices in the months ahead.  Our base case for 2012 includes a modest acceleration of GDP growth accompanied by an improvement in employment and personal income.  US housing prices will finally stabilize and inflation, as measured by the Consumer Price Index less food and energy costs, will continue to rise.  (This inflation measure bottomed at 0.6% year over year in October and now stands at 2.2%.)  The Federal Reserve, however, is likely to keep short term interest rates at virtually zero.  All this points to a significant rise in government bond yields.

The current yield curve for government bonds looks strikingly similar to that which prevailed at the close of 2008.  Based on the improving domestic economy and our assumption that the European debt problems will be contained (admittedly, not a universally held point of view), we think the changes in bond market yields will be very similar to those which occurred in 2009.  If so, it implies interest rate increases in excess of 150 basis points for US Treasury securities with maturities of five years or more.  That translates into a near 12% price decline for ten year government securities.  To avoid these possible losses, investors would need to shrink the average maturity of their portfolios to two years or less and accept current returns of 0.25% versus the 2%-plus yields now available on longer dated investments.

Mortgages, normally a refuge for investors in a rising rate environment, pprobably won’t be a good port of call in 2012.  The market prices of high coupon mortgage securities are astronomical–GNMA pass-thru mortgages with coupons between 5% and 7% are being valued at 110% to 115% of par value.  These premiums are much higher than during previous low yield episodes; for example, GNMA 7% coupons never traded above 106 until mid 2010.  The current mortgage market bubble has occurred because mortgage refinance activity in these premium coupon mortgages has been exceptionally low, limiting prepayment losses for investors.  Borrowers have been unable to refinance because they are underwater on their existing mortgages and lack the equity to meet requirements on new mortgages.  That could all change with the stroke of a pen.

It is rumored that President Obama wants to replace the acting Federal Housing Finance Agency head with a more activist chairman and push for a multi-trillion dollar refinancing plan.  It would permit current borrowers in the government agency guaranteed programs to refinance into lower coupon mortgages with no requirements other than being current on the existing mortgage.  No appraisals, no income verification, no upfront payments.  This is actually a great idea.  It would save consumers tens of billions of dollars a year, increase housing demand and lift home prices, and boost economic growth–in an election year no less.  The losers under the plan would be holders of high coupon mortgage securities who would probably see the market value of their investments drop at least 5%.

While a change in the rules could hurt high coupon mortgages, their lower coupon cousins–the mortgage pass through securities with 3.5% to 4.5% coupons–would be crushed if interest rates rise.  Given the already inflated prices of even these securities, their upside appreciation potential, even in a declining interest rate environment is very limited.  (And we could see that further reduced if government actions unleash a flood of new low coupon securities.)  Meanwhile, they would suffer sizeable price declines and negative total returns if interest rates rise.

Making choices

As we begin 2012, most of our accounts are 20% to 30% below their benchmark maturity targets.  This is at the outer end of our usual duration bands and represents a significant call on the direction of interest rates.  During the fourth quarter of 2011, we added to our holdings of short term US Treasury notes.  We are generally overweight US Treasury securities compared with mortgages.  Nonetheless, a large rise in market yields would result in losses for most of our portfolios.  Accordingly, it is possible in the months ahead we may adopt an even more defensive maturity stance if the economic and political scenario we envision begins to materialize.

In closing, we thank you, our clients, for your support during 2011 and we will continue to work to merit your loyalty in the year ahead.  We wish you a healthy and prosperous New Year.

Note:  The Market Environment reflects the vies of the Investment Advisor only through the date of this report.  The Investment Advisor’s views are subject to change at any time based on market and other conditions.  December 31, 2011.

Thanks again to Strategy Asset Managers for allowing PSI to publish “Bond Market Environment, Fourth Quarter 2011.”

prospects for fixed income in 2012 (II)

January 18, 2012 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Shaping a portfolio for 2012, Strategy Tags: , , , , , , , , , , , , Leave a comment

This is the second of three installments of a yearend analysis of the bond market by Strategy Asset Managers, LLC.

Follow the money

The Federal Reserve recently released its quarterly flow of funds study for the period ending September 30th.  Despite a brisk pace of federal government borrowing, aggregate credit demands remained weak.  Total non-financial debt grew at about a 4% pace as households shrank their borrowings.  This provided plenty of space for federal government debt to expand.  Meanwhile, the Federal Reserve was dumping huge amounts of money into the economy.  A broad measure of money supply–so-called M2–increased 9.8% over the last year.  Lots of money and little credit demand resulted in very low interest rates.  This could change quickly, however.

The US consumer has been tightening his/her belt since 2007.  The bursting of the housing bubble resulted in lower home prices, lower turnover and a decline in mortgage debt outstanding–from $14.8 trillion in June 2008 to $13.6 trillion in September 2011.  Faced with a troubling job market, consumers reduced non-mortgage debt as well.  This peaked at $2.6 trillion in 2008 and now stands at $2.47 trillion.  This borrowing metric seems to have stabilized recently as consumer confidence in future economic prospects has improved.

While the household sector of the economy has been paring back debt, the financial sector–commercial banks and savings & loans–has been reducing debt and balance sheet leverage.  This explains why few are worried about the leakage of European banking problems into our financial system.  So, once folks are ready to buy a new car or upgrade to a bigger house, banks will be able to provide them credit.  Despite the massive (+300%)  growth in federal government borrowings over the last decade, households remain the largest sector of the credit market with $13.2 trillion of debt outstanding versus $10.1 trillion of federal government debt.  If household borrowings increase by just 5%–less than half the rate experienced in the first half of the last decade–aggregate credit demand could rise by 7%.  This rate of expansion is not compatible with the current low level of interest rates.

That’s it for today.  SAM, LLC’s conclusions tomorrow.

Here’s yesterday’s initial post in this series.

fixed income prospects for 2012

January 17, 2012 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Recent Market Action, Shaping a portfolio for 2012, Strategy Tags: , , , , , , , , , , Leave a comment

My first boss on Wall Street, who taught me securities analysis in the late 1970s, switched to the fixed income arena in the early 1980s.  He runs Jamison and McCarthy Investment Advisors LLC, which manages money for institutions and high net worth individuals.  His 4Q11 letter to clients gives a polished industry veteran’s view of the current global economic situation and its implications for bonds.  He’s relatively bearish.

The analysis is very worthwhile reading.  It’s long enough, however, that I’m going to publish it in three posts, all sans charts.  Here’s the first, an outline of the current bond situation:

Is it time to get off the bus?

2011 was a remarkable year.  The bond market encored its 2008 performance as investors flocked to the safety and liquidity of US Treasury securities.  We brought back the same actors–inept central bankers, anxious politicians, sketchy borrowers and frightened investors.  The accents were a little different–more European–but the plot was the same–a financial system supposedly on the verge of collapse.  And the ending for investors was also the same–the frugal, risk averse bond buyer won the prize in the final scene.  The prize in this case was a whopping 30% return from investing in long term US Treasury bonds.  And this came on top of a good showing in 2010–a 9.4% return for US Treasury bonds.  But as all moviegoers know–the third installment in a series is usually a dud.

We don’t think the numbers add up for another bond market rally in 2012.  Last year’s increase in bond prices lowered yields sharply.  For example, the Barclay’s Long-Term US Treasury Index closed the year with an effective yield to maturity of just 2.7%.  This compares with 4.1% a year ago.  The smaller yield means a smaller cushion against any price decline.  Meanwhile, the mathematics of bonds is such that lower yields equal greater price risk for any given change in interest rates.  The measure of risk is called duration and the duration of the Barclay’s Long-Term US Treasury Bond Index on December 31st was 16.2 compared with 13.9 for a similar basket of bonds a year earlier.  Now, investors should expect that a one percentage point change in interest rates would cause a 16.2% change in the price of the bonds, a very nice gain if interest rates for twenty year government bonds fall to 1.7%.  If, however, the yield of such securities rises to just 3.7%–a level 50 basis points below the average of the last five years–get ready to book a 13.5% negative total return (yield plus price change).  Of course, the returns from bonds with shorter maturities would be less damaged.  Nonetheless, there would be plenty of red ink for all.

If you think current bond market returns aren’t very generous, you’re right.  The sub-2% ten year government bond yields produced during the final quarter of 2011 were the lowest on record.  In fact, they were lower than the rate of inflation.  This has rarely occurred.   This occurred during the inflation tsunami of the Seventies, and again, briefly, in 2005 and early 2008 when oil prices spiked.

The bond market has reached these low levels because of:

(1)  fears of a European banking crisis,

(2) the free money policies of the Federal Reserve, and

(3) modest non-government domestic credit demands.

The impact of these factors is being amplified by hedge fund “risk-on, risk-off” trading that pushes short term money between various capital markets.  If any of the three legs supporting the bond market cracks in the months ahead, a substantial interest rate increase is in the cards.

That’s it for today.  More analysis tomorrow and Wednesday.

Shaping a portfolio for 2012 (VI): putting the pieces together

January 11, 2012 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Shaping a portfolio for 2012, Strategy Tags: , , , , , , , , , Leave a comment

my equity strategy for 2012

two caveats:  

–I’m looking at equities as a US-oriented individual investor with a global outlook.  My portfolio will be keyed off the S&P 500.

–I think there’s a chance that the EU is the new Japan.

Two decades ago, faced with a choice of preserving a traditional way of life or beginning a painful reorienting of priorities that would stimulate economic growth, the forces of the status quo in Japan overwhelmed those of progress.  Japan’s economy has since stagnated.  Its stock market, once the largest in the world, is now a backwater.  Its leading companies, other than auto firms, have been surpassed by foreign rivals.  Global investors don’t bother with Tokyo stocks.

Something similar could easily happen with the EU.  Bad for people who live there; not such a big deal for everyone else.  For investors, the EU would become a special situations market.  Portfolio managers would be on the lookout for unique, counter-culture firms, or for international giants who would be European only by accident of listing.   There’d still be the possibility, however, that such stocks would be held back by the general economic malaise andnot perform as well as they would if listed elsewhere.

That’s a worry for the future. My main concern for the present is the transition from superstar securities market to irrelevance.

That process didn’t go smoothly inside Japan, but it had relatively few negative effects on the rest of the world.  Japan was a single country, relatively isolated, and whose banks and government were funded by Japanese citizens.

In contrast, there’s some possibility that if the EU–a bunch of different countries, all dependent on outsiders to keep their financial systems afloat– chooses the Japanese route, the bumps in the road will have considerable negative effects for the rest of us.

How to protect yourself against these possible bumps?

I think this is an asset allocation issue–you protect yourself by having a smaller allocation to equities and a larger one to other asset classes, especially cash.

My equity strategy doesn’t consider that European financial woes might send temporary shockwaves across the rest of the globe.

(Two other points on Europe:  although investors outside the US seem to me to continue to be especially fearful, securities markets have been discounting Eurozone problems for over a year, and increasingly so over the past six months.  Also, I think the worst nightmare of the markets–another “Lehman moment”–is an unlikely outcome.  Even if the failure of a key financial player in Europe were to happen, the world already has a blueprint for action to prevent global trade from grinding to a halt.)

up 10%?

I’d characterize good performance for 2012 as being up 10%.  In looking at an individual stock, my first question is how it will deliver at least that return.  For what it’s worth, I expect stock markets will be volatile throughout the year and that the bulk of the year’s return will come in the second half.

what I’m doing

1.  Three years ago, with the US as ground zero of the financial crisis, it was clear that the US would be growing more slowly than the rest of the world.  So the right thing to do was to avoid stocks that were focus on the domestic economy and heavily overweight those that, while US-based, have the bulk of their profits elsewhere.

That worked exceptionally well until several months ago.   But it’s no longer the right thing to do, in my opinion.  Why not?

–Nothing works forever.  Stocks get expensive, and relative growth rates in the world change.

–Today, economic recovery in the US is broadening and many Americans have gotten excessive debt under control.  The housing market appears to be bottoming after almost five years.  Yes, recovery is slow and unemployment is high.  But changes on the margin are positive and that’s what counts.

–In contrast, Europe is in the midst of a crisis where the outcome is certain only to be one of various shades of ugly.  Emerging markets, while still generally growing more quickly than the developed world, are struggling with overheating.

It seems to me that consumer businesses that address a broad base of American customers and industrial makers of durables and of manufacturing equipment are the place to be.

2.  Market attention is also shifting again–correctly, I think–to larger, more mature companies.

Part of this is that American income-oriented investors are continuing to buy dividend-paying stocks.  Yes, this process isn’t new.  It’s been going on for two years.   And, yes, it’s scary that the trend has hit the newspapers.  But these slow growers are also reasonable ways to play the gradual bounceback of the fortunes of the average American.  And the Fed is likely to keep interest rates artificially low on fixed income for at least the next year.

Not exciting stuff, but investing is about making money–not about glitz.

3.  Not every consumer stock will be a winner.  Over the past couple of years, the clear winners were the luxury retailers and the dollar stores–the consumer bookends of the very affluent and the very not-affluent.  We’re now in a period, I think, of average Americans beginning to spend more freely. So the bookends are not the place to be.  I find it hard to figure out the net result of trading up and having too much bricks-and-mortar retail capacity, however.

4.  I still find IT attractive–e-commerce, social networking, cloud computing, mobile…are all important growth areas in all economies.  A big issue with the sector has been that the index is heavily tilted toward very mature companies.  In the current environment that may be a good thing.  I own a bunch of smaller companies.  INTC is my largest position.

5.  Europe is a place to avoid for now.  Yes, you can pick and choose among European-listed companies that have large exposure to the US or to emerging markets (I’ll confess to owning IHG).  But risks of a particularly unattractive outcome to the Greece-Italy situation are still higher than zero.  So why expose yourself to that possible downside if you can find comparable stocks at reasonable prices in the US?  If you’re going to buy Europe anyway, find something listed in the UK, Sweden or Switzerland rather than in the Eurozone.

6.  I think direct emerging market exposure of some type should be a continuing part of any equity portfolio.  Nevertheless, actively buying individual stocks in any of these countries (with the possible exception of Hong Kong) is financial suicide for just about everyone.  You might just as well burn the money in the street–at least you might get some entertainment value while your money goes up in smoke.

For what it’s worth, I own the Vanguard emerging markets index fund and a couple of the Matthews China-related mutual funds.