By Thomas E. Sobon
The stock and bond markets got whacked in recent days as investors reacted negatively to remarks made by Ben Bernanke at his news conference on Wednesday, the 19th of June. While I would avoid long-dated bonds and bond funds at this time, I'd be inclined to look for bargains among stocks resulting from the indiscriminate selling taking place in the market. With interest rates rising and headed higher, there will be repercussions throughout the economy. In fact, the shock waves are even hitting foreign shores.
What follows is an update to my previous article "Make Hay While the Sun Shines" (dated February 24, 2013). In it I commented on (1) the monetary policies of Ben Bernanke and his buddies at the Fed, (2) some important characteristics of business cycles, and (3) the political divide in Congress. Interested readers may want to refer to it to better understand the substance upon which this article is based.
In effect, I criticized the policies of the Fed and concluded that Bernanke was a modern day Don Quixote. Bill Gross is a heavyweight within the investment community and he recently said, "Bernanke is driving in a fog." So my reference to the well-intentioned but naive Don Quixote is not without merit.
Among other things, his quantitative-easing policies were encouraging consumption while discouraging saving at a time when the opposite was needed to fuel a capital spending cycle. You can't get high employment without such a cycle because well-established theory shows that it is the "accelerator" that triggers sustainable economic growth. But (1) there was no capital expenditure boom in the offing that needed to be financed when the Fed's QE policies were initiated and (2) there is nothing in the history of economic theory that indicates quantitative easing sparks economic growth. In fact, a good case can be made that, in the long run, the QE program will prove to be counterproductive because the longer it is used, the more free market supply-demand balances throughout the economy get distorted. Afterwards, those distortions will have to be corrected in order for the economy to rebase. Furthermore, because of intervention by the Fed, the politicians in Washington had less (no?) incentive to resolve their differences, so the political divide continued. Pursuing biased goals "and" resolving differences within the political body is what politics is supposed to be about. It is not supposed to be about which side of the isle can bicker the most about positions taken by the other.
The Fed failed to reach its stated goal of high employment within an expanding economy. I have to assume that was Ben's goal because he oftentimes referred to the unemployment rate and cited the Fed's dual mandate for justifying his actions. Oh, he did benefit the banks and buy time for the captains of industry to trim their employment rolls and thereby increase operating efficiency. And, during those four years, the corporations gained major benefits from Fed policies. He also created a benign climate for speculators on Wall Street to ply their trade. But the unemployment rate among the nation's work force did not show much improvement. And, at best, economic growth was, and continues to be, tepid.
Because of the policies of the Fed and the political divide in Congress, today's investor has to cope with a troubled economy and the uncertainties of what the Fed and Congress are going to do next.
Confusing? Well, it should be. It's hard to rationalize things that are irrational because of their narrow and/or misguided focus… But … let's see if I can shed some light on the situation extant and provide perspective for the reader.
I do not write an article for the sake of writing an article. If I can't be knowledgeable and finish an article with a timely buy or sell recommendation on an investment security, then as far as I'm concerned, the article isn't worth writing. So let's see what I have in mind and you can decide if this article was worth reading. Writing an article like this requires a lot of time and effort. I'm 83 years old and I don't have time to waste. And, my supply of energy isn't what it used to be. Show me a stairway that leads upstairs and I'll show you a guy who can invent an excuse for staying downstairs. If you agree with me, fine. If not, I would appreciate hearing from you by way of a comment because I could be wrong and, if so, I would like to be made aware of that. My primary goal in life is to prove that my mother did not give birth to a fool so I would be offended if you called me an idiot. The opportunity for constructive criticism is one of the best features provided by Seeking Alpha so don't be afraid to call a spade a spade.
Let the trumpets blare as the saga begins:
Interest rates are the prices paid for borrowing (renting?) money. The die has been cast and the cost of borrowed money is increasing and it's going to increase more during nearby years. Anyone interested in knowing how high interest rates can go when the Fed no longer manipulates them at artificially low levels (as the Fed did since 2008) can see what happened in the years after 1951 when the Fed lifted its 1.5% peg on 1-year T-bills and its 2.5% peg on the long bond. T-bonds were soon applauded as the "Magic 3's", then came the "Magic 4's, and (you guessed it) the "Magic 5's. At the beginning of the 1950's the dividend yield on the S&P Industrial Index (NYSEARCA:SPY) was 2.5 times the yield on T-Bonds. But by the end of the decade T-Bonds were yielding more than the S&P.
As various members of the Fed issued statements in recent weeks (they really were trial balloons) about tapering of QE related purchases of debt securities, the bond markets responded by increasing interest rates which, in turn, put pressure on prices of Treasury bonds as shown in the chart below. I will have more to say about the chart shortly.
But first I'd like to say that the Fed was faced with a dilemma, that was of its own making. If it began to taper its QE purchases of debt securities, the Wall Street crowd would have interpreted that as the beginning of the end for QE and quickly take interest rates up to where they eventually would go. Bernanke didn't want to see a sharp rise in rates. He wanted to see a fairy tale ending where rates rose slowly as the Fed tapered and everybody lived happily ever after. So from time to time various doves at the Fed, other than Bernanke, floated their trial balloons to see what the Street's reaction would be. And invariably the reaction was negative. And invariably, Bill Dudley of the New York Fed would make a statement as part of the dog and pony act to placate the dissenters, and the idea presented in each trial balloon would be shelved. But the genie popped out of the bottle when Bernanke let it be known that tapering would likely begin by the end of the year and end in 2014. The markets reacted immediately, and negatively, around the world.
The situation is bad for investors but if you go outside and look up at the sky you'll see it is not falling as would happen if Judgment Day had arrived. It may take some time for markets to stabilize because the market reaction is worldwide and markets will have to find their bottoms and stabilize.
The legend on the chart lists the S&P industrial index , which is the white line on the chart, and three interest rate ETFs with deferent time durations: the interest rate on the five-year T-notes (^FVX) which is the red colored line; the interest rate on 10-year T-notes (^TNX), the rose colored line, and the interest rate on 30-year T-bonds (^TYX), the black line. Four Treasury bond funds are also listed. They invest in Treasury issues of different maturities: 3 to 7 years (NYSEARCA:IEI) which is the blue line, 7 to 10 years (NYSEARCA:IEF) the pink line, 10 to 20 years (NYSEARCA:TLH) the purple line, and 20-plus years (NYSEARCA:TLT) the brown line. The price and interest rate data for the SPY and all of the ETFs were converted to index numbers so each item has a common base to use as a starting point on the chart and make comparison possible.
As can be seen in the chart, there is a very tight and inverse correlation between changes in interest rates and bond prices. The stock market also varies inversely with interest rate changes but not nearly as closely as the bond funds.
When interest rates spike, it's usually because of a significant event and they usually get to where they are going pretty quickly. Bernanke's comments were the significant event. So now that the genie is out of the bottle, I think rates could sprint higher in the months ahead. Changes in interest rates have their biggest effect on the longest duration bonds. So as interest rates rise, bonds with the longest duration risk decline the most. I think the risk-reward ratio is so bad that bond holders ought to sell and/or avoid long-dated bonds or bond ETFs because of the duration risk involved.
The table below shows numerical data relating to the ETFs referred to.
I frisked and massaged the data and came up with the following conclusions: (1) Six months ago (on 1/16/13) the interest rate on the 30-year T-bond was 3.00%. And since then its lowest interest rate was 2.80% (on 5/1/13) for a net change from its starting point of 20 basis points. So the long bond showed an increase in value of 4.0%.
(2) The interest rate on the T-bond then increased 77 basis points to get to where it is now at 3.57% (on 6/21/13.) That triggered a 10.6% decline in the value of the TLT bond fund.
(3) If the interest rate on T-bond rises from its current level of 3.57% to 4.0% that would be an increase of 43 basis points. And the inverse effect on the value of the TLT bond fund would be another drop of 8.1%, to $99.62 from its current price of $108.37. These estimates are shown on lines TYX-a and TLT-a in the table above. I think that the interest rate on the T-bond will rise to 4.0% within the next few months and then work its way up from there to about 4.5% within a year. If so, the value of the long bond would shrink by 19.6% to $87.16 from Friday's close of $108.37. These estimates are shown on lines TYX-b and TLT-b in the table.
(4) The nice thing about bonds is that their prices can change even if the bonds don't trade because their prices are dependent upon interest rates. So if I can forecast the direction of interest rates, I will know what the directional change will be for bonds. I don't have to forecast a target rate. A ballpark idea of what the real rate might be will suffice. I think the 4.0% to 4.5% estimates I am using are ballpark numbers. Therefore, I am quite bearish on long duration bonds and bond funds.
So (5) why would an investor want to run the risk of being in any long duration bond at this time? If I had to be invested in Treasuries, I'd probably roll 3-month or 6-month T-bills because return "of" capital trumps return "on" capital at this point of time.
As the bond market adjusts to higher rates, good dividend paying stocks like the REITs should be attractive alternatives to bonds, even though the dividend yields on them will become less competitive with the interest rates on the "then" high yield Treasuries. And while the bond market is transitioning to the higher rate levels - whatever they then may be - the REITs should be relatively safe havens for investors because (1) they have high dividend yields, (2) they are well situated in our domestic market and thus removed from problems in foreign countries that will be acerbated by interest rate developments, and (3) while REITs rely on external funding sources to expand their operations, the adverse effect upon them from higher interest rates on them will be marginal…. I will have more to say about REITs shortly.
After the rise in interest rates gets to where it is going, it will be Ok to invest in long-dated bonds again.
The U.S. is a debtor nation and foreigners hold about 47% of all Treasury securities (the Fed owns about 16% and U. S. private parties own 37%). In recent days foreigners were significant net sellers of Treasuries. If they persist in selling, there won't be much that anybody can do to keep a lid on interest rates; and, my estimates could easily be exceeded. Among U.S. holders of Treasury debt, the only significant sellers should be the bond funds. The Fed isn't going to sell and insurance companies buy bonds on yield-to-maturity bases, and far more often than not they hold positions until the maturity date. The only time the underwriters look to take losses in their bond portfolios is when they are looking to offset realized gains in stock and real estate portfolios. So what happens with interest rates will largely be determined by foreign interests.
The next chart shows what is happening in stock markets around the world.
The S&P 500 Equal Weight Index (NYSEARCA:RSP), the white line on the chart, is used to represent the United States. It outperformed all of the markets in other countries for the six months shown on the chart except Japan (NYSEARCA:EWJ), the yellow line, where the market was strong because that country initiated a quantitative easing plan on steroids. In the last 20 days, the EWJ weakened significantly because of pushback by other countries regarding the aggressiveness of its QE program. (It should be noted that the Yen tanked and then recovered when the EWJ rose and then fell.) Bernanke started with the QE stuff (dope?) and gave the idea respectability. Japan decided that it needed a big helping of it to solve its problems. Declines in stock prices during the last three days in foreign markets were on the order of those seen here in the U.S.
Thus far, it looks like the market crash will just be an ordinary, garden-variety kind of market crash and nothing to get excited about.
The next chart shows what is happening with some 20 ETFs that blanket the market.
Here we see that not one of them was immune from the selloff. The poorest performer among the ETFs was the metals ETF (NYSEARCA:XME), the light yellow line on the chart. Base metals like copper and steel do well during a capital spending boom when the economy is expanding and commodity prices are rising; but not when demand for metals is slack and prices are weak. I have something to say about gold below. The XME appears to be accomplishing an impossible feat. It lagged the market badly and got to a washed out level, made a bottom, and then went lower. I'm only kidding; the bottom referred to was a just a "false" bottom.
The next chart relates to gold and gold mining stocks.
These have been disasters for the unfortunate investors who hold positions in them. The price of gold, as reflected in the gold ETF (NYSEARCA:GLD) - the yellow line on the chart - is now well below $1,300. The industry's average cost of mining gold is about $1,300, so at the current price of $1,250, producing it is a losing proposition. The sharp drop in price about 55 days ago occurred when some 200 tons were dumped on the market during a two-day period. The CEO of Newmont Mining (NYSE:NEM) recently acknowledged that there would be no improvement in his company's earnings until the price recovers from its depressed level. I hope he doesn't hold his breath because the likes of the market guru Dennis Gartman recently stated that gold was a broken commodity and the demand for it was marginal, at best. I have seen estimates as low as $1,050 for the precious metal, which is not nearly as precious as it was a few years ago. The last time that shares of Barrick Gold (NYSE:ABX), Goldcorp (NYSE:GG), Newmont and Yamana (NYSE:AUY) traded at lower prices was at the end of 2008. These stocks do pay dividends but current rates may not be sustainable. About the best that could be expected of them in the months ahead is a dead-cat bounce off the bottom.
Despite the gloomy outlook for gold, it is a metal worth tracking. If the price starts spiking upward at some future date, that could be a signal that flight from fiat currencies has begun and bearish sentiment is about to overwhelm stock markets.
When the stock market is trending up, investors would like to get capital gains. When the trend is sideways, they would like to receive high dividends. And during downtrends they want safety of principal. It's hard to find a stock that has the potential to do all of those things. Such a stock would be a very special situation. So when I consider buying a stock, I keep the profile of a special situation in mind, so I can recognize one when I see it.
I am an investor who is 83 years old and it would be ridiculous for me to buy and hold stocks for the long term. If my name was Methuselah, it is probably that I would have very long-term goals. I buy a stock for its near to longer term total-return potential and stay with it as long as the potential exists. I'm always looking to put money at risk as early as the next trading day. So any recommendation that I make must be one that is timely.
It would be foolish of me to write what I wrote thus far and not conclude with a buy recommendation. So let's take a look at some REITs.
It may seem that something is wrong with the rose colored line but the entire chart is correct. I construct my charts by converting price data into index numbers and then use an 11-day base period to determine the starting point value of 50. But few stocks actually start at 50. The price action shown on the chart is for the last 110 trading days but the 11 days prior to that are the base period and it is not shown. This statistical technique is superior to the commonly used same-date approach, which I found to be grossly misleading. The rose colored line is for the RAIT Financial Trust (NYSE:RAS) and the stock tends to move in spurts. And it spurted during the latter part of the 11-day base period. When I see something like that happen, I know immediately that something bullish happened at that time when analyzing the chart.
The bright yellow line on the chart is for the RSP market index. And the white line is for my index of 30 REITs. The RSP gained almost 16% during the 88 days leading up to the peak and gave back a little more than one-third of it during the last 22 trading days. The REITs were the strongest performing group (among 22 groups I track) and showed a gain of 23% at the top. Since then the group gave back just about all of the paper profit gained during the prior 88 days.
Among the 30 REITs, RAIT outperformed all others on the way up and, as of Friday's close, it gave back about half if its paper profit during the selloff. I wrote several articles on RAIT since last November, the last one "RAIT's Turnaround Revisited" was posted on the 10th of June. I had a "buy" rating on it with each article I wrote. And any time I recommended it, I bought shares for my own account. And when I sold shares I wrote a comment to reflect that. My average cost for three purchases was $6.05 and I sold shares 22 days ago when I saw trouble brewing in the market at $8.60 and then at $8.20. I bought some shares back at $7.60 within the past two weeks and I am eager to buy more because my portfolio is under-RAIT-ed at this time.
The stock, at $7.50, is my number one buy recommendation. Last Friday's increase in the quarterly dividend was the 4th such increase in a row and the 5th in the last six quarters. The penny a share increase to 13 cents lifts the annualized rate to 52 cents. In my first article on the subject company last November, I wrote that the quarterly rate could increase from the then current rate of 9 cents to 15 cents by the end of 2013. Well, it looks like that estimate will be achieved. With the stock priced at $7.50, the current indicated dividend yield is 6.9%. The stock goes ex-dividend on July 10.
Success feeds on itself and the string of dividend increases indicates - and rightly so - that RAIT is on a roll. In 2012, its AFFO was $1.10 and the estimates that I have for this year and next are $1.34 and $1.58, respectively. The two analysts who report regularly on the company have higher estimates than me. Their respective numbers are $1.42 and $1.75. I think that RAIT's quarterly dividend rate could increase to 18 cents by Q4 of 2014. On that basis, the indicated annual rate would be 72 cents, which equates to a dividend yield on the stock's current price of 9.6%.
If you want to learn more about RAIT you can read the article I wrote on the 10th of June "RAIT's Turnaround Revisited." And just in case you think I'm looking to increase my page views by referring to it, I'm going to reveal that the editors at Seeking Alpha were kind enough - or out of their cotton picking minds - to give me a generous minimum guarantee, which is not likely to be exceeded, for writing it. And I thank them for that. Anyone looking to put money into the market at this time should also read "Make Hay While the Sun Shines" (posted Feb. 24) which contains the substance upon which this article is based.
The other nine REITs listed in the legend on the chart are all very good REITs and they sport dividend yields ranging from 2.6% to 5.2%. They are all prospering at the current time and have good outlooks for the near-term future. If you want to consider other REITs, I suggest that start by looking at them. I think that they are oversold at this time but, unlike RAIT, I don't regard any of them as being a special situation.
In this magnificent dissertation, I touched upon developments relating to interest rates and investor reaction to Bernanke's remarks. During the near-term future, investors would be well advised to buy stocks they think are going up and cut losses short if they don't. Putting in "low ball" bids makes a lot of sense. Chasing bids, however, is the way to get whipsawed. I will close by paraphrasing The Bard: To buy or not to buy? That is the question.