An incredulous Mr. Bradstreet asks, “I wish I knew how you reach your results.”

Holmes replies: “I reached this one by sitting upon five pillows and consuming an ounce of shag.”

In that spirit — sans pillows and tobacco — it seems I’ve spent a lot of time this week sitting around reading odd stuff and mulling over clues. I did find some clues in the bond market that tell us where the stock market may go next.

You’ll be surprised at what these clues say.

They come from a look back at history. One analyst found that when the beauty contest between stocks and bonds sets up as it does today, bonds get destroyed. “For the third time since the 1850s,” he writes, “30-year rolling real bond returns are near equity returns, and on both previous occasions, multidecade bond bear markets followed.”

And for stocks? Well, this same fellow deduces from the same history that stocks could rise 30% or more as inflationary expectations rise.

Before you scoff at this outbreak of optimism, consider that this is from one of the great students of bear markets. He knows their ways and histories. Heck, he wrote a book about them, The Anatomy of the Bear. And he thinks we’re in a secular bear market for stocks now. (“Secular” being a cherished Wall Street fancy dan word. It means “long-term.”)

So who is this guy and what gives?

Let me preface this discussion by saying that I don’t usually like to guess about where the stock market may go next. We simply play the ball where it lies, like an honest golfer. Besides, we don’t buy the stock market. We buy specific stocks. I think it is infinitely more useful to spend my time looking at specific stocks and to just be picky about what we buy.

Still, I sometimes like to think about the great ebb and flow of market movements. Today is one of those days.

Anyway, the analyst quoted up top is Russell Napier, the global macro strategist for CLSA, an investment firm. He lays out his case in a report titled “It’s Not the Economy, Stupid.” As I’ve often said, you can make money in stocks in a lousy economy. And you can lose money in a good economy. More important is the price you pay for what you own.

Napier shows that relative to bonds, U.S. stocks are cheaper now than at any time in the past 50 years. He speculates that this is probably due to widespread fears of a “double-dip” recession. “But unless that double dip produces a 60%-plus decline in earnings,” Napier writes, “equities are cheap.”

Of course, we can’t rule anything out, and Napier doesn’t. But Napier writes that “at these relative valuations, investors have consistently made material positive returns in every period since the late 1950s. Yield compression alone could push U.S. equities up more than 30%, and if inflation concerns increase, gains could well exceed this.”

Now, before you declare the man insane, I think there is some merit to what he is saying. And it comes with a powerful qualifying comment, which I’ll get to below.

But here is the key…

Napier compares bond yields with stock dividend yields. Dividend yields on stocks are very close to those of 10-year Treasuries. This situation last existed from December 2008 to May 2009. Investors who bought stocks then did well. You otherwise have to go back to June 1962 to find such a narrow gap. Again, investors who bought then cashed in as stocks rose 26% over the next 12 months. There are other historical examples.

As Napier writes, “Investors have consistently made good profits at the current yield gaps and ratios since 1958.”

Back to the Market — A Qualifier

In any event, this is where we are.

Napier’s qualifier is that he’s making a relatively short-term call. Longer term, he says stock valuations ought to decline as bond yields rise. In the early going, though, stocks often rise. As he writes, “This is likely to be the beginning of a very long bear market in bonds, but there is much in the historical record to show that equity prices can continue to rise in the early stages of a bond bear market.”

I won’t tackle that historical record. I will add that valuations can come down without stock prices dropping. Earnings can rise and stock prices can rise more slowly. This is what we’ve seen this year, as the market overall showed much-improved earnings, but the stock market is pretty much where it began the year.

Long term, Napier is not fond of stocks. He simply recognizes the ability to make large gains even in the context of a downward-sloping market. As he points out, the 1970s were an awful time to buy and hold stocks. Yet the 1970s also produced some of the best one-year holding periods for stocks. “Another such great opportunity now presents itself for the nimble and the bold,” Napier writes.

In short, bonds look sunk; but as for stocks, there is room to run. We’ll see if this clue deducing is as good as Sherlock Holmes’.

Sincerely,
Chris Mayer
Penny Sleuth

September 20, 2010

Which Way for Stocks? Bonds Give a Clue was originally featured in the Penny Sleuth.

The two income payers I’m talking about are Public Storage Inc. 6.625% Cumulative Preferred Stock, Series M (NYSE: PSA-M) and Westar Energy 6.1% First Mortgage Bonds (NYSE: WRS).

Fixed income is a type of investment used as protection. It is riskier than CDs at your local bank, but far less risky than regular stocks. Of course, without the proper insight, you can find yourself in equally troublesome situations.

For instance, say you wanted to buy bonds on a seemingly stable company like Tribune Co. For decades, this has been one of the largest players in the media world. The owner of the L.A. Times and Chicago Tribune, Tribune Co. grew revenues to over $5 billion as recently as 2002. Unfortunately, this media empire completely collapsed as the entire newspaper industry fell on its face…leading to the eventual bankruptcy of Tribune Co., leaving its bondholders without a penny.

General Motors was another giant once upon a time. And anyone that bought its bonds just 10 years ago would have looked like a conservative investor. GM, of course, unraveled in the most recent recession, and only an enormous government takeover gave its bondholders a fraction of their initial investment back.

So to say bonds are always safe would be inaccurate. There are plenty of losses in the bond market. And today, that’s even more of a possibility.

I’ve noted several before that there are risks facing the stock market and overall economy. Even a small portion of these risks could play a major role in the bond market, which, in turn, would affect preferred stocks.

But in my opinion, both PSA-M and WRS are among the upper echelon of debt investments. I believe that we have little to worry about with them. Each one is investment grade, which may not be as meaningful as it once was with all three ratings agencies under fire these days. Nonetheless, a credit rating is still the most important statistic for fixed-income investors.

PSA-M and WRS are also plays on incredibly lucrative industries. PSA-M is a debt instrument on storage facility giant, Public Storage. WRS is a play on Westar Energy, a $2.5 billion utility company.

Both of these underlying companies increased dividends on their own ordinary stocks in the past several months. The only time we’d have something to worry about is when these two companies announced a significantly poor outlook or reduced their dividends.

Both plays have done quite well for us since we bought them last year. We’ve held PSA-M since May of last year. In the past 15 months, the preferred shares have increased in value from $19.72 to around $25 today. We’ve also quietly collected more than $2 in dividend payments.

WRS has been almost as beneficial for us. We are sitting on a nice 4.5% capital gain over the last 11 months and another $1.52 in interest distributions.

Both are seeing double-digit gains right now and I expect this to hold up no matter what the market does from here.

Investors typically pull out of their riskiest plays during bear markets. Those would include smaller companies and certain foreign investments. The last place a smart investor takes money from is his fixed investment portfolio.

Both of our debt investments are above our buy-up-to prices. So at this point in time, I don’t recommend you buy more shares/bonds. But if you happen already hold them, don’t sell anytime soon.

That said, there are income plays that are worth getting into right now – many in the preferred share and bond categories… The key to finding the best plays is deep due diligence. If you’re interested in expanding – or starting – your fixed income portfolio, consider logging onto a major ratings site like Morningstar.com; the company offers readily accessible debt ratings and bond data.

In the next few weeks, I’m going to continue looking into these types of ideas to protect your wealth during this turbulent market. It’s important to diversify your income portfolio between growth and safety. These kinds of plays make up the backbone of your income holdings.

Sincerely,
Jim Nelson
Penny Sleuth

August 26, 2010

Fix Your Downside with Debt Instruments was originally featured in the Penny Sleuth.

The jobs of providing economic forecasts/commentary versus trading advice are two completely different roles. One is to predict what the market will do and the other is to profit from how things develop.

At Resource Trader Alert, my premium commodities trading advisory, the focus is on executing high reward versus risk investment strategies to make money. A solid trading plan is developed for each option position with potential entry and exit points determined prior to getting into the market. This money management discipline is designed to eliminate or at least diminish the emotional components of the constant noise in the marketplace.

Opinions: Everyone Has ‘Em – But They Do Not Make Money

You cannot let what you think the market should do impact a well thought out trading plan. At RTA we trade technically what we see in the charts – and sometimes that goes against what we think should happen. The trading methodology of Identify, Execute, and Manage to Maximize outweighs the larger macro viewpoint for the future.

For example, back in mid 2009 we were one of the first to mention the Bond Bubble and profit handsomely from the decline in Treasury prices. The combination of 2008’s safety position unwinding and increased debt sales put the pressure on prices for our trade. The following sharp decline in Bonds from 121 to 112 in June gave us nice profits of $2,200 to add to the RTA track record.

For a trader there is little consolation in being right without the financial payoff.

What Does the Market Tell Us About Interest Rates?

Interest Rates are set to rise currently — there is very little doubt about that with the current Fed target between zero and .25. Short term rates are determined by government monetary policy and remain near historical lows — prices actually went negative because of panic buying in the 2008 collapse – which leaves rates nowhere to go but up. The question is not if rates will go back up, but rather over what time frame they will go back up.

All of this movement and the timing is important to commodity investors because without rising interest rates the dollar continues to fall – and a falling dollar is bullish for our overall commodity portfolio.

To estimate the timing of interest rate moves I always turn to Eurodollar (not to be confused with Euro Currency) futures. Short-term trading instrument prices move in the opposite direction of the interest rates for Eurodollars.

For example the current price of the March Eurodollar of .9973 reflects a rate of .27%. Subtract the price from par at 100 to get that current interest rate. So the market is telling us that rates should remain close to the Fed’s target range for the next few months.

Here’s a look at the last 15 years in the Eurodollar:

Looking past this chart and into the futures market, the deferred months of June (.9955) and September (.9923) for the Eurodollar show a moderate increase in rates has been priced in. These indicate a rate of .45% by June and .77% by September.

But the recent upward Eurodollar price action of nearly 25 points since last Friday’s Unemployment Report has decreased the likelihood of Fed Action any time soon.

Back to Bullish on the Long End of the Curve

Eurodollars, Bonds and notes are not driven by Fed targets but rather supply and demand. With the current fragile state of the economy and no sign of a job recovery it’s nearly impossible to raise rates anytime soon. Keeping mortgages appealing is also necessary for the distressed housing segment.

Ten-year note rates had recently jumped to multi month highs and now sit against the significant 4% yield barrier. This is a solid resistance that should not be violated without the green growth of economic recovery. Not just yet anyways, these are future concerns that will be later trading opportunities.

All of this combined makes our recent Bond trade look very attractive.

Plus, another added bonus is the hedge potential we have from another stock downturn or political/ economic crisis that would create flight to quality and boost bond prices. The outside markets of oil and metals are giving signals that the dollar is under pressure with renewed rallies. It is very difficult for the dollar to fall in an increasing interest rate environment and vice versa.

While the selling of Treasuries may very well be the “Trade of the Decade” all of our information adds up to a buy in the very short term, relatively speaking, with minimal financial risk. Look at this trade as a 100-yard dash for the next couple of months within the larger marathon run of rising interest rates.

It all comes back to commodities,
Alan Knuckman

January 18, 2010

The Facts About Forecasts was originally featured in the Penny Sleuth.

In short, people seem to have had enough of stocks. They’re moving into bonds. Oddly, and as strange as it sounds, this inflection point just might be the turning point for stocks. Put another way, investors as a group just got the last 10 years wrong. Thinking in contrary fashion, they may get the next 10 years wrong as well.

Stocks, as a group, have not done well now for 10 years. As of yesterday, if you had put $10,000 in the S&P 500 10 years ago, you would now have about $6,200 — a loss of 38%. And it’s worse than that considering the effects of inflation.

If you look at bonds, they’ve done much better. The Merrill Lynch U.S. Corporate Master index, a measure of high-grade debt, for instance, has gained 58% in the last 10 years.

You can hear the gears turning. Stocks have not done well, investors reason, and bonds have done much better. Therefore, buy bonds.

That’s what they are doing in large numbers. Here are some telling quotes from a recent Wall Street Journal article. From a manager of $185 million in individual accounts:

“I think a lot of investors have just had it with the equity markets… The baby boomers are saying, ‘I’m too old to make up these losses… I’m not going to risk it.”

Another, who has $414 million in assets under management:

“The credit markets are the market, and the stock market is a sideshow, period.”

One more, from a money manager of $900 million in assets:

“The debt markets seem pretty well understood, while the outlook for equities is still murky.”

Even the Journal itself waxes on about the simplicities of bonds. You only have to figure out if the company can meet the minimum payments of the bonds. You don’t have to worry about figuring out growth rates or what earnings per share may be. “With no end to the recession in sight,” the Journal sighs, “logic for buying equities is wavering.”

(If you’re like me, you’re probably suspicious of someone who repeatedly says “equities” when the plain-old word “stocks” suffices.)

So the stock market has been cut in half… and NOW these advisers are all cheerleaders for the bond market. Already this year, bond funds have added some $15 billion to their assets. Last year, investors took out nearly $200 billion from their stock mutual funds.

Going with what’s worked well in the past sounds reasonable, but investing is an odd thing. It’s not like many other areas of life.

If you get a bad haircut after going to the same barber for a few times, you stop going to that barber and find another. You don’t stick with bad barbers and you don’t go looking for bad barbers.

And if you get a good meal at a restaurant, you keep going back. You don’t worry about the restaurant getting too popular. You don’t look for a dive where hardly anyone goes, thinking you’ll get a better meal.

Investing is almost the exact opposite — which is one of the things that make it so hard. The best way to make a lot of money in stocks is to buy something good that few people seem to want. Then you sit on it, and when people get excited about buying it again, you gladly sell at a premium price and make some multiple on your initial investment.

All the greats made most of their hay in just this fashion — John Templeton buying up small-cap stocks in the Great Depression… Warren Buffett picking up The Washington Post and adding shares of GEICO in the depths after the 1973 market tank… and on and on…

The best deals become available during times like now. That much is a fact. I’m not saying it’s easy. I’m not saying all stocks will rise. Some of them are going to go to zero. Some of them are never going to come back. But some of them are great businesses and have great assets that will certainly come back at some point.

I know it can be tough when stocks you own are down so much. But looking ahead, I can’t help but be more optimistic…

Regards,
Chris Mayer

February 27, 2009

Why You Shouldn’t Move to Bonds was originally featured in the Penny Sleuth.