trend following

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.