Strange things have been happening in the bond market. These actions should be a big caution sign for investors, especially income investors.
In 2003 we warned that interest rates were too low and likely to rise. The great bond bull market seemed over. It looked like prescient advice, especially after interest rates spiked in the summer of 2003. Since then, however, interest rates have declined and bond prices have increased. Most of the action has been compacted in the last few weeks. The 10-year treasury yield is down to about 3.7%.
Rates usually do not fall when the economy and corporate profits are showing strong growth. Also bond prices rarely rise when commodity prices are rising sharply. Bond and commodity prices should move in opposite directions. Bonds are profitable when inflation is falling and the economy doesn’t seem too perky. Commodity prices do well when economies are strong and rising inflation is a possibility.
The paradox is a bit of a puzzle. I suspect it is due to two factors. One factor is foreign central banks buying dollars and U.S. bonds to stabilize the value of the dollar. The other factor is hedge funds. Most likely these funds are borrowing short-term money at today’s low rates of one percent or so to buy longer-term treasury bonds yielding 3.5% to 4%. The trade will work in the short-term. But it could explode quickly if short-term interest rates rise before funds can unwind the trades. A similar whipsaw is part of what caused the historic spike in interest rates in the summer of 2003.
The odds are that either bonds or commodities will change direction.
I know there are many pessimists out there who believe things are worse than they appear. Pessimists should hang on to their bonds and sell any commodity investments they have.
You know that I’m more of an optimist about the economy and corporate profits. I believe in-vestors have been given a second chance to sell many bonds at attractive prices. Inflation is not likely to rise to 1970s-like levels, but we’ve seen the lows for the cycle. A small rise in inflation plus economic growth should cause interest rates to rise and bond prices to fall.
If you haven’t sold intermediate and long-term bonds, especially treasury bonds and bond funds, I recommend doing so now. At the least, resist the temptation to add to any but short-term bond positions.
Income Growth and Income Portfolios
It is time to be cautious about treasury inflation-protected securities (TIPS). I’ve recommended these for a while through Vanguard Inflation-Protected Securities fund. The beauty of TIPS is that each year their principal value is increased to match changes in the consumer price index. Their yields usually are lower than those on regular treasury bonds. The inflation protection should make up for that in the environment I see for the next one to three years.
Unfortunately, other investors finally have caught on to our advice. TIPS have been on a roll and recently were bid to excessive levels.
The way to measure the value of TIPS is to compare their market yields with regular treasury yields. The difference is the expected inflation rate built into the bonds. Recently, the difference on 10-year bonds was about 2.35%. That means the market has priced 2.35% inflation into TIPS. Current inflation is about 1.9% annually. Inflation has to rise for today’s TIPS investor to break even. It is best not to buy TIPS when the spread is greater than the current rate of inflation unless I believe that the market is seriously underestimating the next year’s inflation rate.
TIPS have received too much attention and have appreciated too much relative to regular treasuries. I’m not recommending a sale, but I do recommend that new investors not purchase TIPS until they become reasonably valued. I’ll let you know when it is safe again to buy TIPS. Instead, put new bond money into short-term corporate bonds, such as Vanguard Short-Term Corporate Bond fund.
The rest of these portfolios are as well-positioned as an Income or Income Growth investor can be at this point. They have had modest gains while the overall stock market has been in a correction. Yet even the income-oriented funds in these portfolios started to slide beginning March 8. They won’t avoid all the effects of a correction.
Sector and Balanced Portfolios
The risk takers are fleeing the investment markets.
For the last year, ignoring risk was the way to maximize gains. Investors in the riskiest assets garnered the richest returns. That trend ended as of Jan. 26. The Nasdaq has been in a correction, officially falling more than 10% from its recent peak on March 15. Other market indexes have been flat to down, with the broader market indexes peaking around Feb. 11.
There’s a tug of war between optimists and pessimists. The pessimists point to deficits, the sliding dollar, low job growth, and other factors as signs that the economy and corporate profits have peaked. They say we are in a secular bear market, and 2003 was just a bear rally within that market. I made the optimists’ case earlier in this visit.
I believe we are experiencing a normal correction after an extended rally. That doesn’t mean I recommend throwing caution to the wind with our portfolios. Always maintain flexibility, balance, and a margin of safety. The markets are a constant source of surprise and uncertainty.
Our Sector and Balanced Core Portfolios are filled with funds that are staying well ahead of the market indexes in the correction. Their managers are paying attention to the valuation cycle just as they are supposed to. They cannot avoid losses in every market decline, but they are and will continue to keep us from suffering major, permanent losses of capital.
In the Managed Portfolios, TCW Galileo Select Equity has flirted with its sell signal but had not triggered it as we went to press. I tried to set the sell price so that the fund would be sold only in a significant Nasdaq correction, not a routine retreat.
If the sell signal is triggered between issues, put the sale proceeds in cash and wait for a recommendation in the next issue. It is likely that in addition to correcting, the markets are rotating into market sectors other than those that dominated returns for the last year.
American Century International Bond and Driehaus Emerging Markets Growth have slowed after getting off to fast starts when we added them to the portfolios earlier this year. I believe the decline in the dollar will continue for at least another year, benefiting international bond investors. The emerging markets are largely a piggyback on the U.S. economy. Their stocks should spring forward when the correction in the U.S. markets ends.
Cohen & Steers Realty Shares was a great asset to the portfolio over the last 52 weeks, soaring more than 50%. It even did better than TCW Galileo Select Equity. Because of its conservative real estate investments and high yield, it also has held up better in the correction than the market indexes. That’s why I pulled the sell signal off last month and plan to keep the fund in the Managed Portfolios at least through this year.
Anchoring the Managed Portfolios still is Hussman Strategic Growth. At last report, the fund’s portfolio was 50% hedged against a market decline. That position won’t avoid all losses in a correction, but it will protect most of our capital. In addition, management can increase the hedge any time its model signals extreme market danger. That combination of flexibility and margin of safety enabled the fund to earn over 28% over the last 52 weeks while suffering only a fraction of the losses of the market indexes in the correction. The fund is a great core around which to build the rest of our portfolios in this market environment.