asset bubbles

The Antiques Roadshow

© Can Stock Photo / felker

Everyone knows what junk is: discarded items of little use or value. Yet from time to time some fabulous treasure gets pulled from a trash bin or purchased at a second-hand store for a few bucks. We see these items on the long running television series, the Antiques Roadshow.

This reminds us of our work with a different kind of junk. The polite euphemism for bonds issued by relatively weak companies is ‘high yield.’ Just between us, let’s call them by a more accurate term: junk bonds. From time to time, at rare intervals over the past seventeen years, we have found something we believed to be investable hiding in the junk pile.

A perfect storm may be brewing in the junk bond world. Federal Reserve Bank statistics indicate that the size of the junk bond market has doubled in the past decade, to nearly $2 trillion outstanding. Adding in another category, junk-rated floating rate bonds, puts another $1 trillion on the pile.

1. When financial conditions tighten and corporate results weaken (as they will sooner or later), higher quality bonds may also be marked down to the junk category.

2. The capacity of dealers and other market makers to deal with waves of selling has been dramatically reduced by financial regulations1. Large banks were once players, but trading for their own accounts has been curtailed. Formerly, they stepped in at market extremes to support prices. In the next crunch, they are not likely to be there.

3. We believe some fraction of junk may be held by people who may not realize they own it—hidden in other financial products sold to investors.

4. We have characterized the movement into the apparent safety of bonds over the past decade as a stampede, based on the size of cash flows and the ridiculously low interest rates. (That’s just our opinion.) If that money stampedes out…prices may plunge to lower levels.

Clients, we strive to deal with reality as we see it. The next downturn in the economy is out there somewhere. Our holdings will continue to fluctuate in value, and we will have a down year at some point. But we are excited about the opportunities that may arise in the years ahead.

Junk bonds may not be appropriate investments for all clients. If you would like to talk about this or have something else on your agenda, please email us or call.

Notes and References

1Regulatory Changes Impacting High Yield Liquidity, Pensions & Investments. http://www.pionline.com/article/20151228/PRINT/151229939/regulatory-changes-impacting-high-yield-liquidity. Accessed June 11, 2018.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Floating rate bank loans are loans issues by below investment grade companies for short term funding purposes with higher yield than short term debt and involve risk.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

It Works Until It Doesn’t

© Can Stock Photo / joebelanger

Money poured into tech stocks in the late 1990s. Then it went into residential real estate in the middle 2000s. No wonder: prices marched higher, year after year—until they didn’t.

We humans usually believe that recent trends will continue. When friends and neighbors and coworkers are getting in on the action, it is easy to join them.

A powerful narrative that seems to be creating a lot of wealth is hard to resist. “We have entered a new era.” “This time is different.” “You can’t lose money in real estate.”

Popularity pushes values farther and farther away from the underlying economics, and a reversal usually follows. The bubble pops; a great number of people are surprised. Some end up with losses instead of the gains they felt sure about making.

Our analysis suggests that a new kind of bubble is upon us. The zero interest rate policy or ZIRP of the Federal Reserve Board for most of the past decade led to a scramble for yield. This moved the valuation on many kinds of investments that pay income into very rich territory, in our opinion.

For example, we were recently pitched on a “cash substitute” with a 5% yield, in a supposedly liquid form. Sounds great, right? Perhaps too good to be true.

Indeed, when we took the proposition apart, we found it was made largely out of corporate bonds in financially weak companies—junk bonds, in other words. To make matters worse, the manager pursued opportunities in a thinly-traded part of the market—odd lots, small amounts of each bond that are unattractive to other buyers.

This idea will work until it doesn’t. When the next economic slowdown creates cracks in the theory, investors who believed they owned a “cash substitute” may be sensitive about losses of any size. As they cash out, the manager may be forced to sell into a market with even fewer buyers.

The silver lining for us is that dislocations bring opportunities. Prices overshoot in both directions. One of our roles is to try to spot these anomalies, and figure out which ones are attractive opportunities for you. (We have no guarantees of success in this.)

Clients, if you would like to talk about this or anything else, please email us or call.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

All investing, including stocks, involves risk including loss of principal.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

 

The Tactical Bubble

© Can Stock Photo / fullempty

Our long-time friends know that avoiding stampedes is one of our fundamental principles. We human beings know how to take things too far, history suggests. So we are always on the lookout for trends that may have become too popular.

A year or two ago, in the investment product market, “unconstrained bond managers” were all the rage. With interest rates near all-time low points and risk high, these magicians would own only the smart parts of the somewhat risky bond market. It turns out that all the money that poured into this idea would not fit into just the smart stuff.

We see a new trend today. Solicitations and information about investment concepts and products comes at us all day long, every day. Organizations would like us to send your money to them; human nature being what it is, they usually emphasize popular ideas, or ones that sound great. One term dominates these pitches nowadays.

You know we are contrarian—if everyone else likes something, we believe that alone is a reason to be cautious.

The trendy term is “tactical.” One of the dictionary definitions is “adroit in planning or maneuvering to accomplish a purpose.”

It is out of fashion to simply acknowledge (as we do) that the markets are volatile and fluctuate, an inherent feature that long term investors must face. The popular delusion is to pretend that a “tactical” manager can own stocks while they go up, then sell out to avoid the damage from the inevitable downturn.

It is a great story. Unfortunately, as a wise person noted a very long time ago, “They do not ring a bell at the top.” Is a 1% decline the first step of a 20% bear market? Or is it just the typical volatility that jerks the market around every week or month? No one ever knows.

The risk is that a small decline shakes the tactical investor out of the market, right before it turns around and makes new highs.

We have no issue in being ‘adroit in maneuvering.’ We think our work over the past couple of years shows that we are, hopefully, more adroit than ever. But it stretches credulity to believe that vast amounts of money can all be adroit at the same time.

Investors who have been fooled into believing that volatility can be sharply reduced or eliminated with no adverse effects on performance are likely to be disappointed. We are studying the potential impact if and when the “tactical” fad unwinds. Clients, if you would like to discuss this or any other matter, please email us or call.

Stock investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Tactical allocation may involve more frequent buying and selling of assets and will tend to generate higher transaction cost. Investors should consider the tax consequences of moving positions more frequently.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.

The Longest Journey, Part Two

© Can Stock Photo / lmphot

W is the person we know who made the longest journey to become an effective investor. Before, he chased performance, jumped on popular investments, and focused only on the short-term action of his holdings.

In Part One we profiled how he managed to learn the correct lesson from the Tech Wreck in the year 2000. W learned that popular but over-priced assets are dangerous. Others learned the wrong lesson, “stocks are dangerous.” Those who learned that lesson generally went on to buy over-priced real estate, or withdrew completely from investing.

W profited by owning equity investments in the recovery from the technology bubble, all the way up to the stock market peak in 2007.

Approaching his retirement years, the ensuing market value losses terrified him. He told us later he did not know how he was going to explain to his wife how he had ruined their financial situation.

Although he was tempted to sell out at low points several times during the financial crisis, three things helped him stay invested, but just barely:

  1. The realization that the damage was probably already done, and selling out would only lock in the losses from the peak.
  2. Our relentless reminders of how market cycles work, and the positive perspective that comes from taking the long view.
  3. The dawning realization that portfolio income is what would supplement his retirement—not the market value that appeared on his statements. “If the fruit crop is big enough, why would you have to worry about what the neighbor would pay you for the orchard?”

There is no polite way to say it. W was a difficult client in these years. We spent a lot of time talking him down from the ledge, so to speak. But it was worth it, for the kind of investor that W became.

When the recovery from the financial crisis arrived, W’s portfolio was in position to potentially rebound, and it did. Free from worry about short term action, he could stand to own bargains that might be volatile in the short run. It paid off.

W went through the valley of the shadow of death, and learned that fear was optional. More accurately, he learned that fear did not need to be acted upon. When he emerged on the far side of the valley with more wealth than ever before, his experience had inoculated him against worrying about short term fluctuations.

W had completed the second part of his journey. He had learned two crucial lessons. But he was not yet fully formed as an effective investor. One more lesson was needed. It came entirely from within himself, with no help from us. We’ll write about that in the next installment.

If you would like to talk about your journey or your situation, please call or write.

Part Three

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

This is a hypothetical situation based on real life examples. Names and circumstances have been changed. To determine which investments or strategies may be appropriate for you, consult your financial advisor prior to investing.

Investing involves risk including loss of principal.

The Biggest Stampede Ever?

© Can Stock Photo / afhunta

We think it every day. We’ve written it scores of times. We’ve said it thousands of times. We believe it is the most valuable principle we follow: “Avoid stampedes in the market.”

In our view of the world, a stampede has two criteria: large money flows in, and irrational pricing. For example, in the technology boom of the late 1990’s, very large money flows went into technology stocks. Some were new issues that had no business, no earnings, only a plan. Others were real businesses, but priced five or ten times what they would have been in more normal times.

(We usually speak of stampedes rather than bubbles, because ‘stampede’ connotes herd behavior that is an integral part of the process.)

The flight to safety, or money pouring into the supposed safety of fixed income investments, has reached historic levels. The large money flow satisfies one criteria of a stampede. What about the other one, irrational pricing?

The government of Italy recently issued fifty year bonds. A very few years ago, Italy could barely sell bonds due to the well-publicized economic problems of Europe and the systemic flaws of the Euro common currency. Italian bonds, of course, are denominated in euros. So investors in the bonds issued by a country thought to be going broke a few years ago, denominated in a troubled currency that was born only fourteen years ago, will not get their money back for fifty years.

In a sane world, what ridiculously high rate of interest would be required to persuade you to buy these bonds, if you could even be convinced at any price?

How about 2.85% per year? That is where the bonds were issued. It seems every bit as ridiculous as the most over-priced dot-bomb stock of the tech wreck. Both criteria of a stampede have been met, in spades.

We are working hard to understand the threats and opportunities presented by this stampede. We believe it is the key issue in the markets for the years ahead. If you are interested in how your situation might be affected, please write or call.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

International debt securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical and regulatory risk, and risk associated with varying settlement standards. These risks are often heightened for investments in emerging markets.