We’ve all heard the joke about the quest for the one armed advisor – The one who will give us advice without saying “on the other hand”. This commentary will be chuck full of two handed type guidance. Such is the nature of messy markets and this one is no different. If you want to skip to the “Big Picture” of each section, you might find this easier to digest.
Bonds Now on a Sell Signal
Bonds have once again gone to a sell signal for virtually all types including corporate, high yield, emerging market debt, short and long term Treasuries. Our last sell signal was in mid August, 2012 so this is not something that happens very often. Our system generates asset class signals on an intermediate term basis only so naturally, this sell signal is coming after Treasury bonds and the like are already down a bit. In 2012, long term treasury bonds were down -7.2% before our sell signal tripped. Likewise, the same bond is now down -7.99% from the high for this year set on January 30th. Also consistent with any sort of intermediate term signal is the fact that they often occur at the bottom of a short term decline making the signal look a bit silly as we often see reflex rallies. In 2012, the reflex rally brought long term Treasuries up nearly 5% before restablishing the down trend. On the other hand ! I won’t be surprised to see the same sort of reflex rally now remembering that there is likely more carnage ahead longer term. Steve Blumenthal of CMG posted his regular bond carnage chart again over the weekend showing what happens to your investment in a bond fund when rates move either up or down from current levels. The important thing to note is how much price damage could be done to your bond positions when rates are coming UP from our current historically low level. Take a look.
Impact of Rising Interest Rates
So we have bonds on a sell signal. What does that mean to most investors? Should we make changes to our holdings? How does this impact other asset classes?
As a quick reminder, bond prices and interest rates move in opposite directions. When interest rates rise, bond prices fall as do the value of our any of our bond type holdings (shown in the chart above). Last week, we sold the majority of our high yield corporate bonds as well as our emerging market debt bond funds as both went on sell signals in sync with the Treasury bond market. Sadly, we were hoping for more bang from these trades taken in January. As I have said repeatedly in the last two years, our income model returns are going to taper to around 4-5% annually net of all fees (from 7-9%) until the bond markets see a reset higher in interest rates, both long and short term. Given all the chatter about the Federal Reserve raising rates this summer, our wait might not be that long. So yes, we are following our discipline and cutting bonds out of our investment portfolios as needed.
Rising interest rates are also a negative headwind to equity prices as the current high valuations in the vast majority of stocks are only supported by very low, near zero interest rates according to most analysts’ pricing models. Now, remember that back in 2012 when we had our last period of rising interest rates, stocks were not as overvalued as they are today following some pretty healthy gains in 2013 and 2014. The impact of rising rates in 2012 would not therefore have been as significant then as they are today. You begin to imagine why Wall Street might be a little obsessed with specific words found in the Federal Reserve minutes these days – due out Wednesday by the way.
The Big Picture For Bonds
*Bonds are now on a sell signal
- *Falling bond prices and rising rates making for tough sledding in stocks
- *Expect a reflex rally in bonds BUT remain wary of investing in anything interest sensitive (utilities, real estate, etc) at this point.
- *Income models should be in defense mode now waiting for a developing buy later in the summer.
Stock Market Still Range Bound
I am going to make a bold statement that might be eye opening to you. The majority of the stock markets across the world put in a peak in July of 2014. In March of 2015, most developed countries made another stab at breaking out to new highs but that effort appears to have failed. I think there are still some lingering perceptions that “the markets” are charging strongly higher week after week. That is simply not so. Take a look at the chart below showing the NYSE index in Red and the Dow Jones World Stock index in Green. Notice the final high in July of 2014 with now four failed attempts to move out to new highs since.
This could either be just a healthy consolidation from an overzealous bull market in 2013 or it could be predictive of the typical 8-10% decline we see prior to any cycle of rising rates. Either way, gains and growth in most broad stock market indices has not been what you might think. So where might we find productive investments in this environment?
Remember that we should view things as a market of stocks not a stock market. There are lots of things still moving higher that don’t look like the chart above but they are found in individual stock names, sectors and size boxes only. Healthcare, biotech and pharmaceuticals continue to blaze higher. This is our largest sector exposure in almost all strategies. Technology as a sector also looks good as do financials and potentially banking stocks. One could find gains in a rising US dollar or by way of many managed futures funds that play macro currency moves. We also have positions in cyclical leaders like transportation and consumer discretionary sectors that are benefiting from the massive price declines fuel costs. Finally, we can also continue to own select stocks that are simply marching to their own beat. The only “market” type investments we are holding in our blended asset strategies are small and mid caps index funds and ETFs which are also beneficiaries of a stronger US dollar. So there are enough things moving higher in a non-correlated way to the broad stock markets of the world that we can remain largely invested. At the same time, we’re naturally playing some defense at the same time, careful to avoid much exposure to indices that look like the chart above.
The Big Picture for Stocks
- *Many “stock market” indices peaked last July
- *But there are still lots of things to own that are making new highs
- *2015 is already a year that should benefit tactical/ active management styles
- *The bull market is still intact but adjusting to the prospect of higher interest rates.
- *It is too early to get really defensive but selection is critical now.
*I’ll leave it there for this week as I’m sure your patience for the two armed advisor is wearing thin.
Enjoy the early spring!
Sam Jones
