Brace for Risk in 2015
Happy New Year! My sincere hope is that you and your family and friends had a wonderful Holiday and New Year.
“The future ain’t what it used to be.” Yogi Berra
Brace verb
Make (a structure) stronger or firmer with forms of support. Synonyms: buttress, underpin, hold up. Also: In canoeing/kayaking a stroke used somewhat like an outrigger to stabilize a canoe or kayak.
Risk noun
1. a situation involving exposure to danger.
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I am going to suggest that the single biggest challenge for investors between 2015-2018 is going to be properly evaluating and understanding risk within their investments and their investment options.
So Brace for Risk
This is a picture of my son holding a high brace in the stern of a sea kayak and my wife in the bow smiling for the picture. For 2015, let me be him and you be her. I’ll help you brace for risk if you’ll just smile and enjoy the ride. Ask me all the questions you like as we’re in the boat together, but please get in the boat and stay in the boat.
Bar Harbor, Maine
I trusted him in the stern and to lead his mom at his young age, because he had been kayaking many, many times with me in all kinds of water. That included whitewater rapids, when it was raining (we saw a bald eagle up close that day), flatwater paddling, in the ocean; lots of different environments (even thrown from his boat floating down a rapid needing to figure out how to get to the bank).
I knew he wasn’t going to break any speed limits, but I knew he could help power and brace the boat and his mom trusted him because she knew all of the times I’d been training him prior to that day.
Fortunate for you, the professionals I work with (including me now), all have some gray hairs and wrinkles and we’re not as young as the young fellow in the stern there.
Back to the markets
In many ways, the transitory period that we’re experiencing is a lot like 1998 with respect to the Russian crisis. This time it’s different because the U.S., is not going to go to the IMF asking them to bail out Russia. They’re on their own and you sense that, don’t you?
The oil drop is much like 1986. The oil price bubble bursting does not mean deflation.
It is no more a recessionary signpost now than it was then. To repeat, the oil price drop is overwhelmingly positive – not without some harm, but overwhelmingly positive. This time it is different because several months later, back then, we had a 37% drop in the S&P 500 from Aug-Oct 1987; but I absolutely do not see the same thing happening. If it did, it would most likely be the mother of all modern-era buying opportunities for equities (second only to 2009). The deflation talk is much like 2003. Fade the deflation chatter and noise for the U.S. It is not here. I’m serious. Yields plunged 200 basis points on the “fear factor”, from contagion risks and deflation risks within the world’s good-producing sector as commodities tanked in 1997/1998. This will pass. One of the benefits from all of this (there will be many), is that we most likely have an opportunity to add to our position in the Canadian stock index as the Alberta economy contracts and sends a ripple-shockwave through the Canadian economy (that will pass as well).
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There’s noise and there’s also a trendline
This is why in October 2014 I said we’d get more periodic corrections after the Fed completed Q.E., but that we’d continue to make new highs. I still believe this. Remember I also said not to worry that you can’t make money in bonds and in stocks when the Fed raises rates? In the past 14 Fed rate-raising cycles dating back to 1958, the average return for the S&P 500 averaged +9.6% (source WSJ).
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No deflation like Japan and Europe for the U.S.
Do you know one of the reasons Japan-like deflation is not going to be a fixture here in the U.S., in the next several years? Because now EVERYONE says it is. There’s no way the yields on Treasuries would be as low as they are presently if it were not for Europe and Japan yields being so anemic. We’ve got a 3.5%-4% 2015 U.S., GDP profile, 5.6% unemployment, the net share of companies planning to raise prices back to 2006 levels, the number of companies planning to raise compensation for their employees, credit conditions loosening up (not including energy companies here), the consumer being in incredible shape, and the last two are my country-boy economic barometers:
1) F-150 sales (they are rolling out the door);
2) Lines at established restaurants (you can’t get a table).
Remember, the U.S., consumer represents over 15% of the global economy, importantly, 74% of the U.S., economy, and so when you get the read right on him/her, and you understand the yield curve, you’re pretty far along in understanding the part of the economic cycle we’re in.
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Did you get a mixed bag of 2015 risk prognostications in your stocking to start the New Year?
“It’s like deja-vu, all over again.” Yogi Berra
January 2014 started out just like January 2015 has started.
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Bill Gross “bets” and predicts a down year for many asset classes
The U.S., stock market calendar year result is approximately 77% correlated with the performance of the January monthly performance. If you consider only the third year in a presidential term (which 2015 is), that correlation runs up to 88%. So when Bill Gross, who just so happened to open up a new shop managing bonds (the supposed “risk-off” trade), says last week, “the good times are over...many asset classes will be in the red at the end of the year...”, is he really going out on a limb with his “bet” in saying that? He’s a probability guy. He knows the probability I just cited. So, historically, there’s an 88% chance that if the U.S., stock market finishes in the red in January, it will finish in the red for the calendar year. Didn’t happen in 2014...
Bill penned a report back in December 2008, titled, “Dow 5000”. We didn’t go there and stay there did we? I have never bought a lottery ticket and I wouldn’t even know what to do in a casino because I’ve never been in one, so it may seem odd that I’d take the 12% probability odds, on a market call...so...I won’t!
Morgan Stanley’s Chief Equity Strategist predicts an up year
“The cycle doesn’t die of old age, it dies of some rational reasons – either the economic rollover, corporate arrogance gone awry or credit events – none of which look particularly likely. The bull market for equities could extend into 2020.” Morgan Stanley Chief Equity Strategist, Adam Parker – January 15, 2015
“A year ago it was about emerging markets turmoil and Putin, now we are talking about oil and the euro area - rest assured, a year from now we’ll be turning our attention to other things.” David Rosenberg - January 15, 2015
So...for 2015?
Speaking of the number 15 (2015), we are currently in the 15th corrective phase in this bull market for equities. We may well finish calendar year 2015 in the red in many asset classes. The statistical analysis strongly suggests that if January ends anything like it started, that that might happen. Ok. Now what? Does that influence your investment strategy? I hope not. The reason I hope not is because the key to success is time in the market (with our strategy), not timing the market. It’s easy to say that, but until you get your head around last year’s performance, it is just a slogan. Additionally, by some measures of implied volatility in the markets, we’ve got a more than decent chance of seeing more of the same type of performance in 2015.
So what is your approach to bracing for risk going to be if we see more ups and downs (and we will over the years)?
2014 equity performance geometry
There were 9,956 cumulative down points on the losing sessions, and 11,202 net positive points on the up-days. Whoa - now that’s up and down.
2014 Wall Street bond yield-melt surprise
73 out of 73 Wall Street economists predicted higher rates at the end of 2014. Here’s what actually happened (chart below).
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NOT a know-it-all
I’m not suggesting that the 10 year yield will be higher at the end of 2015 or that though nearly all of the economists surveyed AGAIN say yields will be substantively higher, but what I am going to suggest is that at this point, trying to figure that precise data point out is “noise”. Where the 10 year yield ends 2015 will have more to do with U.S., inflation and what the yields are around the globe in Germany, Japan and elsewhere than what the Fed Funds rate is. You see, I illustrated a Moody’s chart in January 2014 with their call on where they thought the yield on the 10 year would be post Q.E., and it was 3.25%. Based on my research and what I knew
about it, that sounded good. But what none of us counted on was the German 10 year being 0.44% at the end of 2014. When I was in the third inning of sounding the alarm of falling global rates in 2011, the yield on the 10 year German bund was 3%. I actually think that global growth will surprise to the upside and wage inflation will surprise to the upside as well. That may be a tough sell in January and February of 2015.
The real story is NOT the 10 year yield; it is the fact that the 30 year U.S. Treasury bond hit a record low of 2.39% on January 14th, 2015.
So what? I’ll just take my chances...okay...
This is one of the main reasons I’ve been so bullish on corporate and municipal bonds over the years. It’s a supply and demand issue. Not enough supply of safe, nice yielding bonds, and exponential demand. It’s also why I’ve been encouraging folks who are approaching age 50 and older to seriously consider funding a private pension with a fixed indexed annuity with a very inexpensive income rider on it. That sounds really like financial-product-talk doesn’t it? Well, in reality, it’s math. As yields melt, the ability for insurance companies to build bond portfolios with durable yield diminishes. This, in turn, drops the percentages their actuaries and the national association of insurance commissioners will permit the companies to guarantee on their contracts to their clients. I started sounding this alarm when we could secure 8% compounded per year in deferral years and 6% upon payout. These figures are down to 6.5% on deferral and 5% on payout. They will most likely head lower and stay lower for quite a while. So you’re running out of time to secure safe money and actually guarantee it with strong numbers (relative to what else is available in the capital markets).
Just because the Fed Funds rate in the U.S., goes up due to the Fed raising it in the summer does not mean that rates on these types of constructs will go materially higher. Also, it doesn’t mean that it gets any easier in the marketplace for us to obtain higher durable yields. This is the quiet, retirement nightmare that people talk about but they don’t get it, really. Remember 6% money market rates? I do. We most likely won’t see those again for 20 years.
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Attaboy Atwood
Sometimes we highlight our “winners” (investment winners); but to be fair, let’s highlight one of the unrealized “losers” (I think it’s a winner, currently, it’s just getting clocked and accused of being a “loser”, that’s all). This is a corporate bond investment we’ve invested in over the last several months (it’s an opportunity after the oil price dive):
Atwood Oceanics, symbol: ATW, five year, senior unsecured bonds (their only outstanding piece of long term debt), is off 10% for some accounts (in fairness, the company’s stock is down 45% during the same time period). The company has been around since 1968. When we purchased most of the bonds, we picked up a 6.5%-7% yield. Now, when we invest in them, we can pick up an 8.5% yield. Barclay’s most recently had an overweight on the bonds, Moody’s had the bonds subject to upgrade prior to the huge drop in the oil price. Three weeks ago, Moody’s rated them stable. Their huge competitor, Transocean, has many, many tranches of
debt (and billions and billions of dollars of it), and are subject to a several level downgrade by Moody’s.
Risk management
Notably, the ATW bond position averages a 1.25% weighting in most accounts. 
Bar Harbor, Maine
Finding this Atwood bond in this environment is like finding this cool starfish with my daughter kayaking. It’s a gem (we put it back – the starfish, not the bond – the bond, we’re buying more).
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Valuation for equities
Valuations on a forward PE basis are a tad expensive, but keep in mind, given the economic backdrop, they probably won’t settle below a 14 multiple if I were to take a guess. Again, we haven’t had a real correction in a while. (This is a chart of the forward PE).
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“Better to own[certain>my word insertion here] corporate bonds than corporate stocks...” Bill Gross – Pimco CEO - December 2008
Owning a name the right way matters. This means it might make sense to invest in a specific corporate name, but owning the right part of the capital structure is what you want to do.
For example: We bought 6.35% Bank of America bonds (2018 maturity), on July 1’st, 2010 and we bought Wells Fargo stock. The green line is a rough depiction of cumulative value of the bond investment.
The bonds have been paying their coupon just fine and have gone up in value considerably, but the WFC stock outperformance is unbelievable. See the difference?
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Currency and interest rate volatility is back
“Volatility is back. Markets now face opposing currents, more economic divergences and more monetary-policy divergences. All these things are going to bumping against each other.” Kit Juckes, Global strategist at Societe Generale SA in London – January 15, 2015
Response to today’s divergence du jour
India surprisingly dropped their repo rate to 7.75% from 8% and they did it mid-meeting. They did this in response to inflation melting, the country’s declining loan growth and secular increase in household savings since the middle of 2012. Their rates were too high.
Switzerland
It is now difficult to invest in overseas’ domiciled corporations during the currency war as we’re seeing with high value manufacturing like pharmaceuticals and watches. The usually, super-stable Swiss franc whipsawed yesterday when the Swiss National Bank announced that they were going to remove the cap between its currency and the Euro. That is one of the reasons why we utilize the Blackrock Institutional Health Sciences Fund (SHSSX); those guys can hedge, and better evaluate the opportunities from biotech to big-pharma. Now even they got caught off guard on January 15’th. The strategy was clocked for a -1.56% loss on the day. That’s a good bit better than the -11% one day wallop that Roche’s stock received, though.
Humility
No one is immune in this money management industry. If you don’t do this humbly, you’ll be humbled. And even if you’re humble, sometimes you’re humbled.
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Chart of the day that may surprise you
The deficit has improved greatly. You may not want to believe this because of the current administration’s policies, and I can understand that, but the facts are the facts. This is referring to the annual budget surplus or deficit – it doesn’t address the total outstanding short and long term debt. This is another reason why it’s more conceivable that the Fed Funds rate rising to 200 bps won’t be too painful, because we afforded it back then.
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Random thoughts
“The man who reads nothing at all is better educated than the man who reads nothing but newspapers.” – Thomas Jefferson
I like to go back and read some of the stuff I said several years ago to see if I can learn and grow and sometimes I squint my eyes to see if I was right or not.In 2011 I wrote that China and the U.S., faced a fork in the road with respect to interest rates between 2011 and 2015. Well here we are and for an update, we did melt through 2% on the ten year U.S. Treasury and we’re right around there now. The German 10 year bund was ~3% then, now it’s 0.44%. The Japanese 10 year JGB was 1.068% and it’s now 0.27%.
I am getting a sense that with this consumer re-leveraging and feeling like they have some spare jingle, spending discipline is vanishing some for some fortunate Americans. I don’t want to sound like your grandmother scolding you when you were a child, but let’s all be a little careful (and even frugal when it’s appropriate).
Remember I have been saying employment figures would continue to improve and wages would improve and actual inflation would increase? It’s happening right now and nobody’s believing it. The story stuck on page 1 is deflation. But when you remove the effect of the oil price drop, inflation in the U.S., hasn't budged; it’s firming no matter how you measure it.
I estimated $50B in savings in October of last year, due to the price of gasoline drop, and boy was I wrong – I didn’t realize the price would drop so precipitously. Try $100B or even more to the better for the consumer at a time when we will see wages increase. What a tailwind.
In 2012, we invested in 3.25% BBB+ rated Petrobras bonds because of PBR’s (no, it’s not Pabst Blue Ribbon), sheer size and dominance in the industry and their supposed state backing (Brazil). Well fast forward the tape a bit, oil price drop, they’ve added TONS of debt, gotten caught up in a corruption scandal, Moody’s may cut their debt rating several notches, and if they were to go into bankruptcy, it’d be a non-US bankruptcy court handing the proceedings. So, adios el bondo (we sold ‘em).
I think we’ll have a strong U.S., dollar for the rest of 2015 and I think that will pinch profits with a few export-dependent S&P corporations. Gordon Orr, who is the director of McKinsey’s Shanghai office said two weeks ago, “Be careful with national-level statistics from China in 2015. In times of slower growth, they are historically less reliable”.
I’ve been SO, SO very picky w bonds lately. An obscure pick – Travel Centers of America preferred stock 8%+ with an actual maturity date of 2028 (this is very rare – most of these securities are perpetual in nature and are junior in ranking below even subordinated debt). These are senior debt, though. And I think that these guys will keep their noses clean as their largest rival over in Knoxville, TN (Pilot/Flying J), finishes up w the Feds going through their files.
Cloudy skies
The rise in nationalism and protectionism around the globe concerns me a good bit. The terror threat concerns me a great deal. The ideological, political polarity not just in the U.S., but around the globe concerns me. The size of, ever-expanding role of, and the intrusion of government into private society concerns me greatly.
Beautiful skies
On our summit day on Mount Rainier, a crevasse opened up and our guides (former Boeing aerospace engineers), had to shimmy up the mountain ahead of us and scout out a new route. It added several hours to our trip that day, but we were privileged to be the first to go up that section of the Emmons Glacier for the climbing season and it was gorgeous. Sometimes you set out with a course in mind and you have to change course; mid-course. So you make an adjustment. It’s not the end of the world.
My good friend, Bryce Roberts and I on summit day on Mount Rainier
Emotional maturity essential to successful investing? Absolutely.
Two of the most important emotional skills my wife and I are learning that we need to train into our kids (and first and foremost we need them), are: 1) Frustration tolerance; 2) Flexibility.
Can you see how those two skills might help in investing? I can. You see, you can’t give up on a strategy that works just because you get frustrated and you have to be flexible in this new world of investing.
I have a great job and people like you make it possible.
Have a wonderful day.
Yours,
Jack
Jack Parsons
Chief Investment Officer - Vickery Creek