Tax cuts and Bond yields

Yesterday the bill to cut taxes passed in the House. What could passing in the Senate mean for bond yields? Well, we run a budget deficit, which implies that we borrow money as a country-just to finance day to day operations. How do we borrow this money? We issue Treasury notes and bonds backed by the full faith and credit of the United States Treasury. The Treasury has recently decided to start issuing more short-term debt and soften up on issuing bonds around the 10-year mark.

This means that there will be an increasing supply of short-term treasury notes. With increased supply comes lower prices. With lower prices come higher yields on bonds. First, the action of shortening the borrowing duration should flood the market with too much short term debt-increasing bond yields. Second, tax cuts should increase the budget deficit, calling for more treasuries to be issued-more supply. Lastly, the Federal Reserve plans to let $6 billion worth of Treasury securities mature every quarter while also increasing that number by $6 billion per quarter, up to $30 billion.

This means there will be $6 billion less demand for Treasuries this quarter, $12 billion next quarter, $18 billion in the quarter following and so on. This decrease in demand will cause bond prices to fall as less buyers want in. To summarize, The Treasury is issuing more short-term Treasuries (increase in supply-short yields rise), Congress is likely decreasing taxes (increase in supply-short yields rise) and the Fed is letting it’s Treasury securities mature without reinvestment (decrease in demand – yields rise).

If inflation does not surprise to the upside in a consistent manner, this seems like a recipe for higher short rates and long-term rates that are neutral, declining or increasing at a rate slower than short-rates. Either way, a further flattening of the yield curve is in the cards.

 

 

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Another reason we may be seeing such low volatility

When we measure volatility, it pays to think about how a trade is actually completed. As we have seen through many outlets, this year has been one with very few 1% moves in the market. Well, are we all complacent or is it something else. When I want to buy a stock, I go into the market and place a limit order. I may be up against algorithms, but a human programmed them, so essentially the parameters are human. What happens when there is a constant buy pattern, on an automatic schedule? The market would go up steadily.

That may be what automated and index investing has done for us-created a smooth ride up. When a few people decided what is good for us (the index-makers), and we follow herd mentality into it, volatility, or in this case, free thought and action, are less. So now an increasing percent of capital is in an automatic investment plan which tends to focus on index funds. This means less buyers are thinking about price and the index provider is buying no matter the underlying value.

This, in theory, and shown below in practice, has lowered the amount of free-float in the markets.

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To combat any ingrained beliefs about indexing, it is a good idea to read a conflicting view. For this reason I am now reading: The Little Book of Common Sense Investing.

 

Sources: WSJ Daily Shot 9.29.17

Is Money getting to the spenders?

There are a few ways to measure money. M1 is a measure of narrow money. It basically measures currency and checking accounts, among other, less significant things. M2, which is a gauge of broad money, consists of currency and checking accounts, as before, but also includes savings and money market accounts. For ease sake, let’s say that M1 more closely represents money in the financial system and M2 is money that more closely represents the people of an economy.

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As far as the graph above shows, M2, or broad money, has yet to show strength vs. M1. This could mean that money in the financial system is not easily making its way to those who spend. As constantly noted by the media, this has been a problem for a while now. For conditions to be so loose in a monetary sense, and money to be stuck in the system is an issue.

What’s unique in the graph above is that M2 tends to grow at a rate above M1 in the second half of an economic cycle. We have not seen that yet which could suggest we are not running nearly as hot as we should to warrant a recession. When M2 crosses M1, it may be a sign of true recovery.

 

Sources: St. Louis Fed

Indicator Series Vol. 9 : Transports

As a bellwether indicator for economic health, the transportation sector of the equity market tends to foresee a downturn coming. When the transports start under performing the market as a whole, it is seen as a negative. This is likely because the shipping of intermediate and finished goods has dropped off and there is less overall demand being seen on the front lines of business.

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As you can easily see, since the US election transports are hurting.They are under performing the S&P 500 by over 15%. This is surely not a good sign. Keeping an eye on this divergence would be wise.

 

Source: WSJ Daily Shot 11.13.17

Real Risk

Many view risk as standard deviation. That makes sense if you sell every time your investments fall in value. That is not akin to reality for most, I hope. It is more of unrealized risk. The moment you sell the security, it becomes a real risk, and so it becomes a real loss of capital. As Benjamin Graham writes, “…the bona fide investor does not lose money merely because the market price of his holdings declines; hence the fact that a decline may occur does not mean that he is running a true risk of loss.”

He proceeds, “This confusion may be avoided if we apply the concept of risk solely to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position- or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.”

This brings up another form of risk- the price at which you pay. When you buy a stock or bond dear, or without a margin of safety, you lose any advantage you could have had. The likelihood of an unrealized gain is high and a realization of your mistake and a loss of principal becomes high. It is one thing to buy just to see fundamentals crumble, but that may be out of your control. In any case, I believe it is best to look at risk as if is in your mind until it becomes realized.

 

Source: Intelligent Investor

 

 

 

Gold Bugs

Many people laugh at those who love holding gold. It earns no income, it has little industrial utility and it is largely based on scarcity. The last reason is where it gains its popularity. This makes sense as it used to be used as currency, essentially until Britain decided it didn’t need to shore up its gold accounts in 1914 and then later when Nixon hopped off the standard.  As James Grant points out in Money of the Mind, unlike today’s quasi-political Fed, “The consequence of a vote of no confidence was an outflow of gold. There was nothing political in this challenge to the financial integrity of the loser, and the certain response was also apolitical; interest rates were raised and the money supply was reduced.”

Today that is not the case. With open market operations, quantitative easing, operation twist and the like, this is a very different world. So what happens when faith is lost in this newer system? As Jesse Felder points out, below is how gold performs in a crisis.

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As you can see, it does quite well in times of stress. Holding it as a core may be where the grain of truth in the gold bug lore hides, but once in a while, they seem to be right.

 

Sources: WSJ Daily Shot; Jesse Felder, Money of the Mind

 

 

 

 

Expected Return

Expected return is a function of the point on the value curve at which you buy an equity index. If you buy the S&P 500 index at a PE of 40, you probably shouldn’t expect an exceptional return. We sit now with an estimated forward PE of just above 19. as the Credit Suisse chart below shows, hopes can be high, but one should not expect much.

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This chart shows data from 1964 and validates the statements above. When you buy stocks at dear levels, you pay the price in low expected returns. The earning yield, of the EP ratio gives us 5.1%. This is not unlike the 10 year annualized returns seen above.  So, you say, that bonds are not cheap either. This is a fair point, and correlations in a downward move could prove high. Alternatives like long/short, market neutral or commodity-linked funds may be worth looking into if you follow this line of thought.

 

Source: WSJ Daily Shot, WSJ, Credit Suisse