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How the Market Works

Perspective

Posted by kdadmin on July 13th, 2013.

I love my economics research firm, though I don’t think they’re the huggy type. Calling them is like calling the Investment God. I’ve paraphrased my conversation with them on Friday morning. I wasn’t this succinct, nor were they, but you get the gist.

Me: “Hi. Given Bernanke’s remarks in June, their effect on the bond, stock, and currency markets, and the jump in yields and yield spreads, it would seem that I would be better off using a shorter duration in my bond investments going forward.”

Investment God: “Yes … But it’s important to adjust for flights to safety and their impact on the treasury yield. For example, the recent treasury buying spree in the Eurozone.”

Me: “As in they buy treasuries, and the yield spread widens but not because the market is impressed with the treasury prices?”

Investment God: “Yes.”

Me: “Excellent.” (In my best Mr. Burns voice.)

Me: “But as I shorten my duration, I’m still better off in higher yielding assets because of their reduced sensitivity to interest rate or yield changes?”

Investment God: “Yes. Especially because high yields are relatively attractive right now. Their implied yield indicates they should be having a much higher default rate than they actually are.”

Me: “So, the bonds are selling at a discount to what they should be (inflated yields) because we’re at historically low default rates. This won’t last forever.

Investment God: “Right. Not to mention Bernanke’s ham fisted handling of the impending tightening of fiscal policy. The Fed essentially undid the benefits of QE3. I don’t think people actually realize that the growth for Q2 was only 1.7%. That’s an issue and doesn’t point to a strong recovery.”

Me: “I see. So I need to watch the spread between treasuries and the Baa corporates to make sure any changes are not short term ‘flights to safety’ but rather changes to the long term trend. What’s the best indicator of this behavior?”

Investment God: “Corroborate this perspective with correlations in the following data: a strengthening dollar, a falling 10 year treasury yield, and a widening in the corp/treasury spread.”

Me: “Excellent.” (Again, with the requisite Mr. Burns finger tenting.)

Education requires humility. But it provides one with a nose for opportunity…

What this means for you:

  1. Our average account values have improved by 1.75% since June 30, 2013.
  2. High yield bonds with short durations are still a good investment for the near term. Especially funds that we own (PHYTX) that are made of hundreds of different bonds and tend to be less volatile than the popular ETF funds (which are more concentrated by size, and volatile by definition). However, there will come a day when I begin to trim the weight of this position in our portfolios.
  3. Bonds with longer duration could become problematic, especially when our Q2 GDP numbers become more understood by a wider audience. So, I sold them on Friday.
  4. We’re entering a more conventional recovery market phase. As such, I’ll be changing your allocation models over the next few days / weeks / months.
  5. For those of you with outside assets (401k’s, TSA’s, 457’s, 403b’s, IRA’s, annuities, etc.) that haven’t provided us with recent statements or investment options (within 30 days): we need this data as soon as possible so we can make sure that these accounts are properly allocated.

Happy Bastille Day!

p.s. My sailboat is in the water. If you’d like go sailing, please drop me a line.

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