In compiling a lot of recent headlines, I'm getting the inclination that markets are poised to derisk by the end of this quarter. I was working through an article about CALPERS, who released a memo Thursday -- something to the effect of reducing High Yield allocations with PIMCO and Alliance Bernstein (AB):

Because the significant rally in corporate credit is most likely done, reducing exposure to AB... is justified.

Although not as impressive as the stock market’s gains since March 9, in the last year Bbb-rated companies have returned 38%. So the next question becomes: what do we expect those bonds and related ETFs to do next?

Investment-grade corporate bonds may have lagged the overall broad market’s gains, but from a bond standpoint, their performance has been outstanding. Jeffrey R. Kodnett for Kiplinger asks what can be expected from single-A to triple-B bonds.

It is well recognized that asset allocation is perhaps the most important determining factor for investment return and risk. Tracking professional money managers' asset allocations in a timely fashion is thus of great interests. Moreover, being able to track timely smart pros moves is even better.

Various techniques have been used for this purpose. One of widely followed methods is to track mutual funds monthly money flows. This approach could only give us monthly information, which is not exactly very timely in a fast changing market. A more serious problem with this is that it only could tell us how the investors move money among various assets such as equities, fixed incomes and commodities. It does not really reveal what allocations mutual fund managers are making. Furthermore, this would not give us any information how 'smart' managers are doing.

Once again it is time for a goals/progress update. I am pleased to report that annualized dividend income rose in October, extending the streak to 8 months after February 2009’s decline. Since I began publicly tracking annualized dividend income in November 2007, it has increased in 22 of the last 23 months.

In addition, the Chinese and other foreign central banks, despite their complaints about U.S. monetary and fiscal policies, continue to reinvest their trade surpluses in U.S. government bonds. Notwithstanding the very bleak longer-term outlook for government bonds, the U.S. for the time being is having no trouble selling its debt. Yields on riskier classes of debt have generally fallen to unattractive levels. Corporate bonds, which were a relative bargain at the start of the year, have recovered so much that in many instances absolute borrowing costs have fallen to their lowest levels in 15-20 years. Similarly, municipal bonds no longer offer the attractive yields and spreads they had early in the year. TIPs, while still a better value than traditional Treasuries, do not offer the same level of protection from fiscal profligacy as they did early in the year. "Break even" inflation rates, derived from nominal versus inflation protected bond yields, have moved closer to long term averages, with the 10 year rate now pricing in around 2% inflation, up from a low of 0.5% in January.

Back in the day when bonds acted as a safer haven, investors often rotated out of stocks and into bonds. Since the March lows, however, all assets have gone up together.

In fact, during the credit collapse, virtually everything went down together. Stocks, non-U.S. Treasury bonds, currencies, commodities, REITS, MLPs, preferred shares, precious metals – it really didn’t matter. Liquidity was king.

I’ve gotta say—I was a bit surprised by the opening life of Evan Simonoff’s column in the October Financial Advisor magazine. He said “Who among us (referring to the financial advisor community) really takes this 60% rally in equity prices seriously.” He then goes on to say it's “remarkable” how many observers are convinced this rebound is for real.

Evan’s column, The Long View, which I read most months, usually provides careful analysis to its arguments. However, this month I was a bit disappointed. Simonoff cites Liz Ann Sonders throughout the article who, it turns out, is actually pretty optimistic about the big market bounce. I didn’t find much if any of the solid data I would expect from an article which looks to support an overall bearish sentiment amongst advisors. Based on what I’ve been hearing at recent financial advisor conferences around New York City, the sentiment is anything but bearish. So let’s take a look at why some advisors might actually take this rally in equity prices seriously.

October 27, 2009



LIKE WALKING THROUGH A MINEFIELD

As investors continue to watch the dollar fall in value and fear inflation, bond ETFs have been the beneficiaries of this economic situation.

John Spence of Market Watch said that taxable bond ETFs brought in the biggest gains in assets in September. Year-to-date, taxable bond ETFs have brought in about $26.7 billion of new assets, which makes it the most popular ETF category so far in 2009.

Yale Professor Robert Shiller has devised and maintained a so called "Cyclically Adjusted Price Earning Ratio" (CAPE10) as an alternative to the popular P/E ratio to value the US stock market. CAPE10 is defined as the ratio of price to the average of last 10 year trailing S&P 500 annual earnings. In his now famous book titled "Irrational Exuberance", Shiller popularized this ratio as a long term stock market valuation metric. As it stood last Friday, October 23, 2009, the current CAPE10 is 24.08 while the long term average CAPE10 (since year 1881) is 16.34. This implies that the current US stock market is 35% over valued.

It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to Warren Buffett's stock market metric, ValidFi implements and maintains a live strategy called Shiller Cyclically Adjusted P/E 10 Stock Market Timing Strategy. One of its model portfolios buys stocks only when this ratio is deemed to be significantly under valued (the current CAPE10 is 33% lower than the long term CAPE10 average) and goes into cash when such a ratio signals significantly over valued (if the current CAPE10 is 50% higher than its long term average). The stock market exposure is through buying Wilshire 5000 total return index (^DWC). From 12/31/1970 to 10/23/2009, the weekly adjusted portfolio achieved 7.5% annualized return and standard deviation 9.5%, compared with Wilshire 5000 total return's annualized return 6.9% and standard deviation 19.5%. Such a portfolio was in cash from 7/17/1987 all the way to 3/6/2009. See the following chart:

Fixed income has been popular among the ETF set, spurring rapid growth within this market. But is this rapid growth and popularity having consequences?

As a rule of thumb, bonds and ETFs that track them invest in stocks that can be hard to trade. As investors continue to seek returns within the fixed income market, especially with ETFs, the indexes upon which the funds are based are becoming compromised, reports Randall W. Forsyth for Barron’s.

By Matt Hougan

The basic premise of most corporate bond indexes is flawed. There has to be a better way.

October 15, 2009



DIP BUYING CONTINUES

Logic argues for a rest but Mr. Market’s not giving much ground. Some of this may have to do with options expiration tomorrow as those who can hunt down strike prices, forcing exercise and hitting stops. Sure, it’s a mean game.

Rebalancing is a key to lower risk and higher returns because it forces the discipline and takes the emotionalism out of “buy low and sell high.” The illustration below shows how a simple portfolio that has a target allocation of 50% bonds and 50% stocks gets rebalanced as the allocations move away from their targets.

Even before starting her eponymously named firm, Meredith Whitney had won the role of Queen of the Damned in the drama that has played out on Broad Street (not Broadway) these past few years as a bank and finance analyst for Oppenheimer & Co. The golden haired siren has co-starred opposite the dark and brooding Nouriel Roubini, a.k.a. Dr. Doom, using a script adapted from the Swiss investor Marc Faber’s GloomBoomDoom report.

The show has been a barn burner, almost literally, and has kept audiences glued to their screens, both television with hopes of hearing the next tidbit of news from these prophets of the apocalypse, as well as their computers watching heretofore AAA-rated investments morph into CCC-rated toxic blobs.

Last week we published a visual view of price range probability cones for several securities (SPY, FXI, TLT and UUP). This article builds on the concepts in that article and provides a tabular view of the same kind of data for twenty-seven asset categories.

The two tables below show the maximum and minimum price change that statistics would suggest are probable over the 21 trading days after October 9 (last Friday), based on 21 days (1 month) and on 63 days (3 months) of historical price volatility.

A previous post on bond ETFs elicited requests to explain why it is important to look at the yield-to-maturity instead of the yield quoted on financial portals like Yahoo Finance. Just why, for example, is it misleading to use Yahoo Finance’s quote of 4% on the iShares Canadian Short-Term Bond ETF [TSX:(XSB)] when iShares.ca’s website quotes the yield to maturity at 2.1%.

Exchange traded funds (ETFs) have many of the built-in advantages that mutual funds have, but there are also differences. In my view, the biggest difference is not the fact that ETFs trade throughout the day or even how ETF pricing works, but rather that ETFs have a very short operating history.

We use both mutual funds and ETFs so I am not at all negative about exchange traded funds, but I am aware that there will be growing pains as the ETF industry matures.

The challenge faced by investors seeking a respectable and reasonably secure stream of income from bonds is this: on one hand, you want to protect yourself against future inflation risk, which is accomplished by keeping the average maturity relatively short (i.e. under five years). On the other hand, you can't bring the average maturity in too far without damaging the income flow, due to the Fed's zero percent interest rate policy and the resulting steepness of the yield curve. Cash is unattractive, because you don't want to earn a negative real return. Meanwhile, yields on lower-quality bonds, such as high yield corporates, no longer seem to offer any margin of safety.