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The Chronicles of Reflation - Behind the iCurve 4.0

| January 09, 2014
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Happy New Year!

I sincerely hope that you and yours had a wonderful holiday season and that your 2014 is going very well.

"Economists have a tendency to take the most recent experience [disinflation / deflation], and extrapolate it into the future."  David Rosenberg - December 2013.

"There is a serious lag with inflation data - always has been and always will be".  Will and Caroline Parsons' dad - January 9, 2014

iCurve 4.0

So that I'm communicating as clearly as possible here... 

  • The iCurve is the Inflation Curve (not to be confused with the interest rate yield curve).  This is what the Fed is intentionally falling behind;  they want much, much more inflation; at this point, let's presume that they're gonna get what they want; 
  • 4.0% is the approximate range in this next cycle we need to be watching for with respect to the Fed Funds interest rate (currently at 0.07%).  We are in great shape and are well-positioned for both the near term and the long term.  We have held to a very disciplined approach to entry price points with both equities and bonds. 

We will be covering the following topics in this Insights:

1) Brief 2013 Review;

2) Building equity positions and owning bonds;

3) Theoretical versus practical

  a) policy rules;

  b) inflation measures;

4) What to do when all assets are a tad bubbly;

5) Some legislators say your IRA is too big;

6) Where the 10 year US Treasury yield may be after QE is completed;

7) Buy low (out of favor), and sell high (popular), examples;

8) Rosenberg's big call on inflation;

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Please note that the Research tabs on the lefthand side (you may also click below), of this page have been updated for 2014.

Moody's 2014 Global Interest Rate Outlook

Vickery Creek 2014 Investment Themes

Global Macro Outlook - highlighting China, Japan, and Europe

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1) Brief 2013 Review

You may remember my saying in late July of last year that we were seeing wage inflation picking up - that's very much a 2014 story.  More household income in the aggregate will obviously be a good thing.  Remember that the U.S. consumer represents 15% of annual GLOBAL GDP.  That's a staggering figure.

I also said then that without QE we'd be sitting closer to 3.5% on the 10 year US Treasury and the bond market's trying to tell us that QE is over by January 2015 (or at least that it needs to be).   

You may also remember that years ago, I was talking about a Yellen-led Fed complete with Fed forward guidance pegged to inflation similar to Sweden; and the possible introduction of rate caps.  We may still get all of that manipulation.  But guess what?  QE at this point is doing so much more harm than good.

Not just a bond shop

(Performance Review) Overall, the 2013 calendar year (point to point), performance for the equity portion of our portfolios was roughly +15% to +30% net of fees and the bond portion varied greatly depending upon your price entry points (and ratio of corporate bonds to municipal bonds), but the return range was roughly +0.59% to +5.5% (these are unaudited figures).  

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2) Building positions

These are some of our notable institutional stock funds in our asset allocation mix that we are continuing to build positions in despite the possibility of our being in the midst of a mild equity market correction (5-10%).  Which, this would be good, because we've got a global synchronous economic growth story in 2014, but we haven't had a breather in the U.S. stock markets for quite some time and we are in need of one.  We are also in need of another bond selloff as well to help take some of the froth off of corporate bonds (See down the pagenot much is cheap, Fed Governor Jeremy Stein's comment nearly a year ago).

Some notables...

FMIHX - Fiduciary Management Inc., of Milwaukee - Large Cap fund that is closed to new investors but open to Vickery Creek clients.

HASCX - Harbor Small Cap Value - managed by sub account advisor Earnest Partners of Atlanta with an outstanding track record.

BFGIX - (low asset size), growth fund; and low star rating which I like (under the radar), but outstanding overall results compared to the Russell Mid Cap from 1986-2013.  Namely, this particular growth style complements my low price / sales and overall adherence to a value style with individual equities in the portfolios.  Ron Baron buys stocks that are more expensive than ones I'd typically buy but he does it effectively. Importantly, he has a sell strategy; this fund has great capture while also doing well in down markets.

OFDIX - O'Shaughnessy Enhanced Dividend Institutional Fund.  Most of the names are domiciled in Europe.  Like it or not, Europe is on the mend - the possibility of renewed drama certainly exists, but it mostly priced in, I believe, and the fund is managed by Jim O'Shaughnessy.  Jim wrote a book called What Works on Wall Street and I still use that reference book and will most likely consult it quarterly for years to come.  Notably, the fund has a $1mm minimum, but a $1000 minimum for Vickery Creek clients and the dividend is running over 4.3% currently.

EWSS - I ike Singapore Small Caps over the next ten years - GDP troughed last quarter unless China's banking system implodes - which is more than possible.  But we are building slowly in that name in an attempt to dollar cost average some good price entry points.

What about the bonds we own?

If they're in your account, I like them.  And if I'm buying them today, I like them for whatever interest rate outcome comes our way.  I feel good about them if we see a significant bump in rates before 2018 and I feel good about them if we trade in a low range for the next ten years.  It wouldnt be inconceivable for us to be in a low interest rate environment for twenty years (See slide 42-VC Inv Themes 2014).  Since the August 2012 timeframe, we have not been buying corporate bonds and municipal bonds in full earnest - meaning we haven't been buying full sized positions due to the runup in bond prices.  The risk/reward is not what it used to be pure and simple.  So much money has chased yield and thus forced prices higher (that's something I've said was coming for years and years you'll recall).  So if you own bonds in your portfolios with us it's because they should be in there - we sold more bonds in 2013 than I've sold in my entire career (all years combined), due to duration risk (effect of higher interest rates).  But you see your price point matters and owning higher coupon bonds matters because those bonds will carry well as rates rise.  

You know how you feel about how much you might pay for a particular investment?  A house or a car or a piece of art?  You'll pay _$ but you won't pay _$ for it?  The same philosophy applies to investing in bonds.  Just because the bonds are available doesn't mean you should pay too high a price for them.  There are bonds to buy, it's just that the places on the yield curve and the bonds in 2014 are different than in 2012 and 2013.  So either you buy something else, or you just wait for a better price... 

Not much is cheap

February 7'th, 2014 marks the one year anniversary of Fed governor, Jeremy Stein Fed saying, "We are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit."  And that makes sense doesn't it?  Are you seeing folks scramble again like they did in 2000 to buy a home with people lined up arguing and fighting over it?  The same applies to other assets as well.

Bonds 101:  Back to clipping coupons 

This is not a bad thing, it's just good to be aware of it - that broadly-speaking, price appreciation in corporate bonds and muni bonds is over - at least for this next cycle.

"Every portfolio benefits from bonds; they provide a cushion when the stock market hits a rough patch.  But avoiding stocks completely could mean your investment won't grow any faster than the rate of inflation."  Suze Orman

Let's pick on two bond investments...

  1) A BUY - We are buying more Cooper Tires (symbol: CTB), Corporate Bonds that carry a 7.625% coupon to 2027 (13 years), today at a dollar price of $99.30 mindful that S&P and Moody's placeed the bonds on negative watch (middle of last year), due to the Apollo deal.  Apollo is an Indian tire manufacturer and they and Cooper tried to merge.  It was WAY too leveraged of a deal.  The company may still try to do a stupid deal like that but I believe wiser heads will prevail and the execs will actually have to keep clocking in like the rest of us until they can cobble together a better deal than that one to cash out.  It's one thing to do a deal that's beneficial to shareholders, but that deal was AWFUL from the start.  I am glad the deal didn't go through and I'm still bullish on the bonds and buying with new money.  The bonds and the stock are trading as though the company isn't going to pursue a bonehead deal and are viewing the batched deal as a credit positive event.  These bonds are not callable (or refinanceable), by the company and so they have to pay you the interest despire the gargantuan efforts by the Fed to induce debt refinancing by everyone.

  2) A SELL - On 6/30/11 we invested in RR Donnelley (symbol RRD), Corporate Bonds that carry an 8.6% coupon and mature in 2016 - we paid roughly $105.  Those bonds were B rated at the time and since then have been upgraded to BB-.  The bonds paid us our 8.6% a year and the bonds traded as high at $117 earlier in the week.  That represents a roughly 1.7% YTM for the person (bond fund), that bought them at that exhorbitant price.  See why I've been saying most bond mutual funds have some seriously gross times ahead?  You don't want that.  You want to buy them at $105, but come on,  1.7%?  For that risky thing?  We sold them yesterday at $115.77.  That's an 11.77% annualized gross rate of return.  In my conversation with one of my bond traders and a peer out on the west coast, the three of us agreed that the RRD trade was a gift, and that the company may not even be in business due to how leveraged they are and their business model and that the bonds didn't make sense from a risk/reward standpoint.

The reason for bonds

The reason you own a reasonable chunk of corporate bonds and municipal bonds is so that when the stock markets get walloped, you have a cushion and don't get hammered so.  Ask any of my clients who were with me in 2008 how they fared - they'll tell you.  If you have friends that say, "Oh, your guy is so wrong - you should be all in stocks and you shouldn't own any bonds", have your friend call me.  I can help them.

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3a) Theoretical Federal Reserve policy rules versus practical policy rules

"Ignoring the levels of rates...is why policy settings are so out of whack with traditional [practical] rules.  There are significant market effects, because when rates do rise, they will have to do so (too), fast."  Kit Juckes - Global Strategist, Societe Generale - January 7, 2014

Two years ago, in Manhattan, I spent time with Henley Smith (in the video below who manages some of the bond investments for Mario Gabelli's wealth management firm).  We were with a panel of CIO's discussing just how far the Fed would go and be willing to go to try to make up for lapses in GDP growth and he and others on the panel disagreed with me that we'd get to this point.  And do you know what?  Why wouldn't they?  When the Fed's policy began to shift in 1993 and again in 2003, they were adhering to a much more traditional set of rules.  They didn't fall this far behind the inflation curve.  

We are in uncharted territory (Fed policy), and it seems very impractical and very theoretical at this point. And I agree with Fed governors Plosser and Fisher (who are voters on the Fed this year), it's time to wrap it up.

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3b) Theoretical (BLS), versus practical (industry), inflation measures

"In theory there is no difference between theory and practice.  In practice there is." - Yogi Berra

Keep in mind, the employment data is going to get so good in 2014, and the Fed knows it, that they're now working on their inflation forward guidance communication.  Look for some really fancy acronyms in 2014-2016 (programs), coming out of the Fed around inflation targeting.  Keep in mind that the BLS (Bureau of Labor and Statistics), told us early last year that it would take until 2018-2022 to get the unemployment rate down to 6.5%.  Well here we are.  1) Apparently 80% of those who left the workforce in 2013 were over 55 (so we're dealing with the available labor pool shrinking dramatically due to the aging baby boomers).  Also in the BLS's defense, they maybe weren't counting on:  2) the overall participation rate dropping to multi-generation lows.  But, unfortunately, that's what happens when, in 39 states, if you consider (study source: Cato Institute), that a person who takes full advantage of federal and state aid, can make as much income as a secretary to not work, then why participate?  

I understand their (the BLS), statistical reasoning after talking with a friend who works at the BLS and writes white papers for them.  They exclude certain things from their calculations.  But I think the BLS is way off base with respect to what I'll term practical and transactional price inflation measures compared to their (and the Fed's), PCE deflator that has been so adjusted and rearranged (it's called hedonics in statistics), that at this point, it's missing the point.

     1.2% does not equal 6%

The airline industry group, to which Delta Air Lines belongs, says that their revenue per passenger YoY is UP 6%, and yet the BLS says that that sector has only 1% price inflation.  If we were looking at a difference of 1.2% versus 1.4% it might not be a big deal, but I think the industry group ought to have some idea of what sort of transactional and practical pricing inflation they've got.  Don't you?  

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4) What to do when all assets are a tad bubbly 

Liquidity...then pop...?...

"In the present era of Fed accommodation, a 12 percent increase in the monetary base may seem insignificant, but at the time, the liquidity injection helped fuel a massive melt-up in stocks. The Nasdaq, for instance, saw an 85 percent gain between September 31st of 1999 and March 10th of 2000, crashing 72 percent by the third quarter of 2001 as the tech bubble popped." Scott Minerd - Nov 7, 2013 - Guggenheim Partners

Since August of 2012, I've been thinking that this uber-accomodative Fed policy needed to be updated.  The Fed is intentionally falling behind the inflation curve and if you think things "feel" inflationary now - just wait.  The Fed's narrow measure of inflation (the core PCE deflator index), is running about 1.2% at present.  They are saying that they will not only tolerate 2.5%+ in that measurement, but that's what they want.  That means they'll tolerate quite bubbly conditions.

Larry Fink (CEO of Blackrock-world's largest investment manager), said November 2'nd, 2013 - "I'm now seeing real bubble-like markets again."  The last time we saw this was 14 years ago.  This may not end well.

So...what happens then?  What happens when the Fed starts seeing data points approaching/surpassing that 2.5% reading on the PCE deflator index?  

Don't take the bait

We really don't know - that's why we prepare for a wider range of potential outcomes.  That's also why, though the Fed is telling people to go out and borrow and buy and spend more than normal, I think we should not take the bait.  Be wise.  Except in special circumstances, Deleverage.  Manage your spending wisely.  Invest.  Save.  Gift appreciated assets.  Be keenly tax aware.  

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5) Some legislators say your IRA is too big (FIA solution)

That's right - you read that.  There is legislation that proposes to limit your IRA to $3mm and also legislation that tries to do away with your ability to plan to stretch that IRA for your heirs' lifetimes.  It's not law, and some might say it'll never make it into law.  Maybe.  But with very high limits on how much you can invest in a fixed indexed annuity, which is a form of tax-deferred retirement account, you may want to consider one this year.  Please talk with us to make sure that you match up the correct construct with your particular objectives and that you understand what you'll get out of it and that matches up with what you want.

"A government big enough to give you everything you want is a government big enough to take from you everything you have." Gerald Ford

You can invest in these low-cost fixed indexed annuities for guaranteed, tax-deferred, income sources with competitive rates of return and you can't outlive your income from these in retirement.  That might be a smart move if Prof., Yellen and team run into some potholes during their tenure and your important investment years.  Even if they orchestrate the normalization of interest rates in a perfect, pothole-free manner, this is a strong investment.

In some cases, I like it (certain FIAs), as a bond-alternative

This could be the year of the zero annual cost (from contract value), fixed indexed annuity that credits you 5% compounded with a payout of 5.15% at age 65 off of that number.  If you talk with any financial planner who is thinking smartly about capital markets assumptions for the next twenty years, he'll tell you that net of fees and tax-free during deferral and then guaranteed payout of 5.15%, that's a real deal.  And it's not dependent upon any political or monetary policy to achieve that result.

If you've put this element of your financial plan off because of whatever reason, do it this year.  And if you think since "rates are going higher", you'll wait.  Don't.  Higher 10 year Treasury rates won't necessarily translate to higher rates offered by insurance companies.  It may mean higher CD rates as the Fed Funds rate comes out of a coma, but they'll still be anemic and that's taxable.

Think of the investment as a private pension.

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6) Where the 10 year US Treasury may be after QE is completed (source: Moody's)

A lot of people I talk with want to know where I think rates will be at certain points in the future - I'm not a prophet or a fortune teller, I don't know - I have some idea I suppose, but...

This is where Moody's says the 10 year Treasury (which influences all rates), will settle in after QE is concluded.  I agree with this approximation.

Possible impact on corporate bonds

"Certainly, there will be some impact.  If you have a rise in rates, investment-grade corporates will probably be the most vulnerable.  Securities such as high-yield corporates and bank loans tend to be less affected.  That's because, for high yield right now, about three-quarters of the overall yield is coming from the spread [the difference in yield between the average of issues in the benchmark index and 10 year Treasury], not from the Treasury curve itself.  So, if Treasury rates move up, it will have an impact on fixed income investors, but, in general, a lot of that could be absorbed in the spread; spreads could compress." Eric Takaha - Portfolio Manager, Franklin Templeton Strategic Income Fund - June 2013

Boy, did Eric call that?  Spreads on bonds (since his call in June of last year), have traded tighter than the new gasket seal on the intake manifold of the 302 V8 engine that my neighbor and I are rebuilding.  Now that's (unlike the old one), tight!

Liquidity for stocks and risk assets...then pop...?...

"In the present era of Fed accommodation, a 12 percent increase in the monetary base may seem insignificant, but at the time, the liquidity injection helped fuel a massive melt-up in stocks. The Nasdaq, for instance, saw an 85 percent gain between September 31st of 1999 and March 10th of 2000,crashing 72 percent by the third quarter of 2001 as the tech bubble popped."Scott Minerd Nov 7, 2013 Guggenheim Partners

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7) Buy low (out of favor), and sell high (popular), examples  

Do price / sales ratios matter?  Does popularity matter?

Alcoa pays a 1.25% annual dividend and has had a brutal time the last several years.  We began buying shares a year or so ago with the shares down 50%.

  • Alcoa was dropped from the Dow on September 10, 2013 and Visa was added in its place.

From October 7'th - mid-day November, 4'th, the difference in the stock price performance wasAA (Alcoa), +24% vs., V (Visa), +3.6%.  OK...you say...that's not a very strong argument for the long term.  You'll get exposure to Visa in your FMIHX mutual fund.  I'm just not going to buy the individual name.  But I'll start building a position in Alcoa at $9-$10 based on what I think it's worth in twenty years.  You may think I'm crazy, but Visa's stock value may not be worth more in twenty years than it is today (call me crazy)...

Consider this...

the Price / Sales ratio on Visa is 13.4

the Price / Sales ratio on Alcoa is 0.4

Which is cheaper?  Buy LOW and Sell HIGH? 

  • Selling Sony (SNE), and Buying Canon (CAJ)

We've made 50%+/- on Sony shares and Canon's shares are -20% YTD paying a 4% dividend with virtually no debt (I know Canon has their work cut out for them).

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8) Rosenberg's big call on inflation

I am highlighting this Rosenberg video because I agree with his call on inflation.  He talks a bit about his call on cable and media (we leave that sector bet to the institutional money managers we hire to make those decisions). Although, I do think Verizon (a media distributor), shares are becoming attractive at these levels and sport a 4.5% common dividend...

Did you notice what Rosie said?  He said prepare for inflation.  He said stocks, corporate credit (bonds), [and for us, no government bonds].  That approach plus kicker municipal bonds (yields kick higher if not called), is the right approach.  

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Conclusion

We are going to do our best to: fully understand client goals; be patient; care a ton about entry price points; be diversified; be mindful of risk/reward; fully understand time horizons for investments; sell losers and even some winners; but mostly hold winners.

I sincerely thank you for your trust in my leadership and for your business. 

I have a great job and people like you make it possible - thank you.

Yours,
Jack 

PS - Enjoy one of the latest Wizard of Id cartoons

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