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Within the major equity category, asset classes are often thought of as US, non-US developed, and emerging country stocks.

Correlations between those major categories have converged somewhat in the past, but in 2008  they approached unity.

If equity class correlations equal “1″ there is no allocation benefit relating to diversifying the volatility within the equity class.

This correlation table for 1-year returns for various Vanguard mutual funds (with ETF proxies for those mutual funds) shows major and minor equity categories lining up in 2008 with correlations approaching “1″.

Securities listed in image:
VFINX, VTSMX, VFWIX, VDMIX, VEURX, VPACX, VEIEX,
SPY, VTI, VEU, VEA, VGK, VPL, VWO

Asset allocation with regard to equities will work better when correlations begin to diverge.

Richard Shaw
QVM Group LLC

This does not constitute a recommendation of any kind.  It is a screen that produces food for thought only.  There are probably some stinkers in the list and maybe some good opportunities.

The reason to use the screen would be to find positions that could yield more than buying the index, and that could be balanced among the sectors differently than stocks are balanced within dividend funds (such as DVY, SDY, and VIG).

Before presenting the results, here are the criteria we used to build the screen, showing how the universe reduced as more criteria were applied:

• All stocks covered by S&P Outlook (9,969)
• Market price >$5 (5,281)
• Paid dividends since 1998 or earlier (1,482)
• Market capitalization >= $500 million (853)
• S&P earnings and dividends strength rating B+ or better (493)
• Dividend payout ratio < 100% (390)
• Long-term debt <= 50% of capital (301)
• Trailing yield >0% < 10% (296)

We used the 10% cap on yield along with the S&P financial strength rating to minimize troubled situations.  There are some stocks paying more than 10%, however, that might not be troubled.  Also, some high yielding major names with more than 50% leverage, such as GE, are not included.

The filter is based on the assumption of use by a yield seeking investor who also wishes to limit the amount of leverage employed by the companies in the portfolio.

Note that we did not limit the search to stocks within the S&P 500 index, but did select stocks based on the same industry classifications used in the S&P index.

All filter data is from S&P.  All yield data is from Morningstar.  Charts are from StockCharts.com. The data tools for this or similar screens are readily available to retail investors from those vendors at low monthly costs.

XLB (3.9%), IP (8.00%), AA (5.60%), GEF.B (5.40%), PPG (4.80%), SON (4.80%)

XLE (2.0%), COP (3.40%), MRO (3.30%), CVX (3.30%), ECA (3.20%), PCZ (2.70%)

XLF (8.0%), MI (9.20%), HOG (7.4%), STI (7.20%), TCB (7.10%), BBT (7.00%)

XLI (3.5), MAS (8.20%), HNI (5.20%), OTTR (4.90%), AXB (4.90%), AVY (4.80%)

XLK (2.3%), T (5.50%), MOLXA (4.40%), INTC (3.60%), ADP (3.20%), IBM (2.20%)

XLP (2.9%), MO (8.40%), UVV (5.90%), CAG (4.50%), KMB (4.30%), SYY (4.00%)

XLU (4.2%), AEE (7.40%), PNW (6.30%), ED (5.90%), ATG (5.30%), ALE (5.30%)

XLV (2.7%), PFE (7.00%), LLY (4.80%), JNJ (3.00%), ABT (2.60%), MDT (2.20%)

XLY (2.5%), HOG (7.1%), MDP (4.8%), VFC (4.10%), GPC (3.90%), WHR (3.90%)

Take this for what it is — a quantitative screen, and nothing more.

There is no analysis beyond strictly applying the filter criteria, which may or may not produce good results, or be suitable for you.

Not all found companies are necessarily attractive, and not all attractive high yielding companies have been found.

This filter is just a way to reduce the field of examination in the search for investment ideas.  More quantitative and qualitative review is necessary to determine if any of the identified companies could be attractive investments for any particular portfolio.

Other filters generating other lists should also be evaluated.

Richard Shaw
QVM Group LLC

]]> http://www.qvmgroup.com/invest/archives/1311/feed http://www.qvmgroup.com/invest/archives/1289 http://www.qvmgroup.com/invest/archives/1289#comments Sat, 03 Jan 2009 02:06:20 +0000 RichardShaw http://www.qvmgroup.com/invest/?p=1289 We have been saying recently that long-term US Treasury bonds looked toppy (see Dec 25, 2008).  Long-bond funds gapped up, which is often an invitation to fill the gap later in a downward movement. T-bonds reached very low rates (as short-term Treasuries approached zero). After the gap up, the long-bond and related funds began to move sideways, and today declined a bit. The T-bond yield charts (inverse to the price charts) show rates moving up somewhat from very low levels.

Related funds such as TLT (long) responded accordingly.

The inverse of TLT, which is TBT, created a mirror image.

If you believe that we have sustained and deep deflation ahead, the long-bond dip may be a buying opportunity.  If you believe that we have long-term inflation ahead after a deflationary dip, this may be a shorting opportunity. If you are thinking of trading, then it would be best for you if your view of the technical factors is aligned with your view of the fundamental factors. It’s always best to have major technical trends and fundamental forces pushing in the same direction. A rear-view look at Treasury rates tends to suggest higher rates are ahead.  Really, whenever a price of anything is historically high or historically low, it tend to come back toward the middle.

click images to enlarge

Because the current situation is a reversal question, you need to be careful and confident in your reasoning, or your fingers could be burned. One day does not make a market trend for stocks or bonds, but it does appear for now that fear on the equity side is reducing from peak levels according to a lower VIX. Reduced fear of stocks is a negative for low yield Treasuries.

Given the divided opinions of experts with extreme variations in views, and the surplus of bifurcated predictions from single sources with abnormally high upside and downside ranges, all we really have as a truth sayer at the moment is the price action itself. Current market condition assessments are half-empty or half-full.  Future projections by noted experts and investment personalities are depressingly negative or ebulliently positive. Note that T-bonds can crash.  They have done so before, as this 10 year monthly futures chart shows:

This short-term daily futures chart tells the same story as the yield and fund charts above.

Unlike voiced and written opinions, prices are verified facts.  Prices of futures and options are opinions backed by people taking risks with their cash.  That doesn’t make them right, but it does make them worth watching. The options prices on TLT (the long-term Treasuries ETF) clearly suggest a drop in the price of Treasuries (a rise in the rates), because the price (adjusted for in-the-money and out-of-the-money amounts) of Puts is higher than the price of Calls:

The options open interest on TLT is less clear, because the leaps have higher Call open interest than Put open interest, however the nearby February ‘09 options show higher Put open interest than for Calls:

• Feb ‘09 $120 Put OI = 875, Call OI = 611
• Jan ‘10 $120 Put OI = 200, Call OI = 141
• Jan ‘11 $120 Put OI = 106, Call OI = 47

Yes, read about and listen to views.  Consider what professionals who devote themselves to market analysis have to say.  Analyze their arguments, their biases and their conflicts using a critical mind, but also watch the prices, and the futures and the options before you decide to put your money down.

Sometimes the markets (crowds) are right, and sometimes they are wrong.  Short-term, markets are more right than wrong most of the time, because until they end, trends are self perpetuating.  You just need to recognize the endings.  Easier said than done, but it can be done.

We tend to think there is a short-term reversal in the making for the T-bond.  Intermediate-term, we have no view. Long-term, rates must rise and bonds must fall.

POST SCRIPT:

We published this article yesterday to follow-up to our “Treasuries Bubbly - Will Disappoint” articles of December 24 and 25, only to discover this morning (the day after) that the lead story in Barron’s is “Are Treasuries Safe?”.  Since Barron’s articles tend to be market movers, being aware of their well distributed thoughts is a good idea.  They said;

“Long-term Treasuries now yielding less than 3% could fall 25% in value as the recession ebbs and rates rise … it’s time to consider alternatives, like munis yielding up to 6% and even junk bonds paying 20%.”

We aren’t so sure about the recession ebbing, but we think Treasury rates could rise anyway, as yield seekers look elsewhere, and as major buyers such as China, Japan and the UK demand more for their money in the Treasury markets.

They quote Mohamed El-Erian, co-CIO of PIMCO (operator of PIMCO Total Return — PTTPX, the largest bond fund in the US)  as saying “Get out of Treasuries.  They are very, very expensive.”

They expressed concerns about inflation following the “super-accommodative” Federal Reserve policy, and and about the likely sequence of asset rotation out of Treasuries into higher yielding debt, and then to equities as the economic situation improves.  That is a point we have been making and that still makes sense to us.

Treasuries were the beneficiaries of fear and they will be abandoned by the once fearful, when they feel the market storm has past.  The improvement is likely to occur, and seems to be occurring, first in other debt classes earlier and more dramatically than in equities. This chart we put together shows the recent price changes by capital type, supporting the idea of price improvement cascading down the capital structure from highest quality bonds toward common stock at the bottom of liquidation priority.

[securities in image: TLT, MUB, LQD, HYG, PFF, SPY]

Barron’s likes inflation protected Treasuries (see our TIP of TIPS from Dec 26) which they think could earn over 5% annual yield over the next 10 years if inflation averages 3%, it’s recent historical norm.

They say the consensus is now that Treasuries will fall.  However, they point out that the Merrill Lynch economist, David Rosenberg, is concerned that “imploding” household wealth and the prospect of a 3% contraction in the US economy in 2009, and perhaps into 2010, could push 10-year Treasury rates to 1.5%.  That scenario would be a bull case for Treasuries.

We think getting of the way of currently declining long-term Treasuries is prudent.

Richard Shaw
QVM Group LLC

• US stocks
• world stocks ex US
• US equity REITs
• global commodities
• US aggregate bonds.

click image to enlarge

Richard Shaw
QVM Group LLC

Among the convertible securities funds, we like Vanguard Convertible fund the best (symbol VCVSX).  Unlike most other types of bonds, there are no ETF products for convertible bonds, although there are some preferred securities CEF products. We have no current opinion about the CEFs, except to say that generally we prefer mutual funds or ETFs over CEFs.

VCVSX versus convertible CEFs:

Those convertible CEFs with over $100 million of assets and 5 years or more of history are: JQC, NCV, AVK, CHY, and CHI. Here is how their recent performance compares to VCVSX (shown in solid black line).

Convertible Funds versus Other Bond Fund Types and the S&P 500:

We prefer VCVSX for convertible bond (and some preferred) exposure.  Here is how that fund compares to other types of bond funds and the S&P 500 in terms of yield, credit quality and duration.

click image to enlarge

Type, Yield, Credit Quality, Duration, ETF Alternative

Credit Rating Agency Scales

VCVSX is rated Ba2 (speculative grade, below investment grade, “junk”)

Chart Comparisons - Types of Bond Funds:

Bond ETFs have a relatively short history.  The chart that follows compares the Vanguard Convertible fund (VCVSX) to an intermediate Treasuries fund (IEF), an investment grade corporate bond fund (LQD), a high yield bond fund (HYG), and a national municipal bond fund (MUB).

The convertible bond fund has experienced the deepest drop in value over the past 18 months, and has recovered less than the high yield (junk) fund.  That is either a warning sign or a remaining opportunity to buy depressed bonds before spreads improve.

Chart Comparisons - S&P 500 versus Aggregate US Bonds versus Convertibles:

We use VBMFX for Barclay’s Aggregate US Bonds (alternatives: AGG, BND), and VFINX for the S&P 500 (alternatives: SPY, IVV) in these charts.

19 Years

10 Years

5 Years

1 Year

3 Months

Management:

VCVSX is managed for Vanguard by OakTree Capital Management and a dedicated, convertibles-only team overseeing about $7 billion of convertibles.  VCVSX has about $700 million of assets. Larry Keele is the portfolio manager.

Portfolio Composition:

The average coupon is 2.5%, but the SEC yield is 4.95% (below par market valuation - no net conversion premium).  Portfolio turnover is 78% per year.  Holdings are 7.3% convertible stocks, 84.1% convertible bonds, and 8.6% cash reserves.

Credit quality spans Moody’s “Aa” (investment grade) to less than “B” (worse than “junk”) with nearly 36% “not rated”, with a net “Ba2″ average quality (middle “junk”).

click to enlarge

The top ten positions account for 27% of assets.

Returns and Expenses:

The fund is actively managed, and therefore does not have the bare bones expense ratio of an index fund, but the ratio is still moderate at 77 basis points.

Returns through 11/30/2008 have been:

• 1-year: -34.81%
• 3-years: -5.37%
• 5-years: -0.67%
• 10-years: +4.42%
• since inception (6/17/1986): 6.79%

Why Not Just Buy High Yield Equities?

We may be at or near an historic opportunity to purchase equity assets at bargain prices. If you are certain of that, then high yield equities may make better sense.  We are still tentative on equity recovery and will likely remain so until after January.

The  “get paid while you wait” argument can be made with beaten down equities, but the risk of value falling (even permanent loss) is greater with equities than with bonds.  The higher in the capital structure you are, the lower the risk of permanent loss you have for any given issuer.

US Treasuries are at the top of the global capital structure, and are being flooded with Dollars.  The result is historically low yield and possibly significant risk of capital losses as eventual market recovery causes assets to be reallocated out of Treasuries into higher risk / higher potential return assets (both bonds and stocks).

Also, until the “E” in “P/E” becomes more believable and stops being revised down, and until the “G” in “PEG” becomes more believable and stops being revised down for both companies and countries, it is hard to say which equities are really cheap and which are really expensive.

Therefore, we prefer to be higher in the capital structure until more of the smoke clears.  Convertibles are a bit higher than equities, although generally below traditional bonds, and certainly lower in the national capital structure than Treasuries and municipals.

We have been stepping into municipals, investment grade corporate bonds, preferred stocks, inflation protected Treasuries (see TIPS article), and a little bit of high yield (below investment grade) bonds.

Conclusion:

We think the history of the convertible class, and VCVSX in specific, and the transitional condition of the bond and stock markets, support including convertible exposure in small amounts for those accounts which are suitable for inclusion of speculative (”junk”) assets.

Being paid more than twice the treasury rate, and about the same as the overall bond market rate, to wait for a possible capital gain from a future conversion premium seems to us to be a more conservative form of speculation than taking a direct equity position.

Since the yield on convertibles such as VCVSX is more than 1/2 of the long-term total return on stocks, we are comfortable with the long view for 1% to 5% of assets within an overall allocation, depending on the investor profile.

The author currently holds 2% of personal assets in VCVSX.

[Securities mentioned: SPY, IEF, AGG, LQD, HYG, MUB, VFINX, VFITX, VWITX, VBMFX, VWESX, VCVSX, VWEHX, JQC, NCV, AVK, CHY, CHI]

Richard Shaw
QVM Group LLC

The best answer would be to own an oil well, or better yet, own an entire oil exporting country.  However, neither of those options is a practical answer for most investors, certainly not owning a country (unless, of course you are born into the right family).

So what are the practical options for the rest of us?  Among others, they include:

• futures contracts
• funds that invest in futures contracts
• exchange traded notes that are priced to a futures index
• royalty trusts that own oil in the ground
• integrated oil companies
• oil & gas exploration companies
• oil & gas production companies
• general energy funds
• alternate fuels
• options on any of the above.

Options are a speculation that expire in time, so we’ll exclude them from the “ownership” consideration.  Futures provide a 1:1 price participation, but they also expire with time, and rolling from contract-to-contract can create losses if the far contract is more expensive than the near contract at rollover.

Let’s look at other oil related categories which you can “own” without time limits to see how they correlate with the price of oil.

First, as a base, this chart shows the weekly price of West Texas Intermediate Crude for the past three years.

The charts that follow plot the percentage performance for the past three years for West Texas Intermediate Crude versus an investment alternative — either a directly investable security or an industry group from which you could chose one or more companies to own.

Dow Jones US Energy Industry Group

Dow Jones US Oil & Gas Producers Industry Group

Dow Jones US Exploration & Production Industry Group

Dow Jones US Integrated Oil Industry Group

Dow Jones US Equipment, Services & Distribution Industry Group

Dow Jones US Equipment & Services Industry Group

Dow Jones US Pipeline Industry Group

Dow Jones US Coal Industry Group

Natural Gas

ISE-CCM Alternative Energy Index

Prudhoe Bay (Oil) Royalty Trust

Canadian Oil Sands Royalty Trust

S&P 500 Energy Sector (passive)

Vanguard Energy Fund (active)

XOM

BTU

USO (ETF)

OIL (ETN)

Observations:

The equipment and services industry within the oil and gas group is the most leveraged to oil prices — up the most on high oil prices and down the most on low oil prices.

Oil and gas producers and integrated oil companies did not rise as much or fall as much as oil, perhaps serving as indicators of overbought and oversold oil price conditions — more of a long-term outlook than a spot price outlook.

Coal mining companies are highly correlated with oil prices.

When oil gets a cold, alternative energy gets pneumonia.

The unitholders of the US oil royalty trust, BPT, aren’t overly worried about current oil prices, as shown by their unwillingness to sell as prices that track downward spot oil price movements.

Canadian Oil Sands (COSWF) tracks spot oil fairly closely.

Energy funds aren’t particularly well correlated with oil spot prices.

The oil futures ETF and ETN (USO and OIL) have charts shaped like spot oil, but they underperform.

Conclusion:

If you expect oil to go to higher prices (such as the approximate $70+ often cited as “fair value” in terms of finding and lifting costs for replacement oil), then you would be best suited to own something that tracks oil closely.

If you can earn dividends while you wait, that would be better.

We would like to own BPT, because it is fractional ownership of oil wells without other business activity risks, but we’d like to see the price lower.

We do own some Canadian Oil Sands (COSWF), but Canadian tax laws are forcing trusts to change structure, and we are a bit uncomfortable with the uncertainties around all that.  Nonetheless, we will be buying some additional units.

Coal, which powers 1/2 of our electric production, tracks oil nicely, making companies such as BTU potentially attractive oil plays, as well as electrical plays.  If coal liquifaction gains traction, it could power both our future Chevy Volt and our antique Oldsmobile 442.

Richard Shaw
QVM Group LLC

Note, that unlike an individual bond with a fixed interest yield and yield-to-maturity, bond funds have turnover which causes portfolio yields to change.

To provide some historical perspective, the following charts plot the 19 year history of US Treasuries with maturities from 1 month through 30 years.

Richard Shaw
QVM Group LLC

After this difficult year, we expect more investors will consider bonds as part of their portfolio and a volatility moderator.

Aggregate US Bonds:

Aggregate bonds (excludes short-term and muni bonds) are ahead, due to the strong performance of Treasuries.

The two leading ETFs for the Lehman Aggregate US Bond index are AGG from Barclays and BND from Vanguard.  The Barclays product has more trading volume, and uses limited sampling to track the index.  The Vanguard product has lower fees and holds many more securities in its sampling.

click images to enlarge

[shown: AGG, BND]

US Bond Types:

Treasuries are bubbly and showing fatigue at the long end (see prior articles: 12/24/2008 and 12/25/2008).  Mortgage-backed securities (MBB: mostly from FHLMC and Fannie, with some GNMA; and VFIIX: primarily GNMA) are well ahead for the year.  Investment grade corporates are nearly recovered. High yield corporates are beginning to show life.

[shown: SHY, IEI, IEF, TLH, TLT,
MUB, MBB, VFIIX LQD, HYG]

High yield bonds, investment grade corporate bonds and some other types of bonds available through ETFs experienced some large premium and discount deviations from net asset value in the October - November period.  Mutual funds that trade at NAV did not deviate.  (See our article on Broken Arbitrage for bond funds). Note, however, that some of our readers suggested that the ETF deviations were a better “finding of value” in the frozen credit markets than the bid information used by mutual funds to calculate NAV — we have no way to tell which is the correct view.

Weekly line charts (instead of the daily candlesticks above) for key bond types are in a recent article.

National Municipal Bonds:

National municipal bonds appear to be doing well by looking at MUB (an ETF), but that view is not fully supported by looking at a series of Vanguard muni funds shown below.  The shorter-term munis are not too far off earlier 2008 levels, but the other maturity ranges have a way to go.

[shown: VWSUX, VMLTX, VWITX, VWLUX, VWAHX]

The muni funds invest in bonds within different maturity ranges (or quality in the case of high yield):

• VWSUX (1-2 years)
• VMLTX (2-6 years)
• VWITX (6-12 years)
• VWLUX (10-25 years)
• VWAHX (high yield).

Inflation Protected Treasuries:

Inflation Protected Treasury Bonds are in a class by themselves, because the are “real assets” that fluctuate interest payments with the CPI and mature at the greater of par or cumulative inflation adjusted principle (see Tip on Tips).  They have a way to go to recover and are not likely to do so until inflationary concerns become more prevalent.

[shown: TIP]

Convertible Bonds and Preferred Stocks:

Convertible bonds and preferred stocks (which have both bond-like and stock-like attributes) also have a way to go to recovery.  Because preferred stock is always subordinated to bonds, and since convertible bonds are generally subordinated to non-convertible bonds, these two types of securities would be expected to recover later in the economic cycle.

[shown: VSCVSX (convertibles) and PFF (preferreds)]

International Bonds:

Among non-US bond index funds, BWX (investment grade, local currency denominated sovereign debt of developed market countries) is mostly recovered.   EMB (US Dollar denominated sovereign and quasi-sovereign debt of emerging market countries) is making strong recovery progress.

[shown: BWX and EMB]

US Bond Fund Short-Term Returns:

This chart is updated weekly on Saturdays and
available on our website.

Global and International Active and Index Fund Short-Term Returns:

This chart is updated weekly on Saturdays and
available on our website.

Richard Shaw
QVM Group LLC

About Ordinary Treasuries

Ordinary Treasuries pay a fixed amount of interest twice per year and mature at a fixed principal amount.  Treasury interest for US-persons is exempt from State and local income taxes, but not Federal income taxes.  Treasuries can reasonably be held in taxable or tax deferred accounts.

About Treasury Inflation Protected Securities (TIPS)

The principal amount of a TIPS adjusts to increase with inflation or decrease with deflation, as measured by the CPI. However, the maturity value of a TIPS is the original principal amount (”par”) or the adjusted principal, whichever is greater.

TIPS pay interest twice a year, at a fixed rate (not a fixed amount). The fixed rate is applied to the inflation/deflation adjusted principal.  Therefore, the interest payments rise with inflation and fall with deflation.

If inflation occurs while you hold TIPS, each interest payment will be higher than the last. If deflation occurs, each interest payment will be lower than the last.  At maturity, the principal payment will not be less than par, but could be more than par if net inflation occurred during the life of the bond.

Both the interest earned as well as any increase in principal value on a TIPS are taxable at the Federal level for US-persons.  Since the increase in principal value is a non-cash income, TIPS are best held in tax deferred or tax-free accounts.

Inflation/Deflation After 1929 Crash:

There is a debate as to which past bear market is most like the current bear market.  In reality each bear and each bull is different — different economies, different regulations, different banking institutions, different political and geopolitical conditions, etc. — but comparisons are inescapable.

If we use the 1929 crash as a model, the post-crash inflation/deflation pattern may be helpful in thinking about TIPS.

The 5-year annualized deflation following the 1929 crash was 4.74%.  The 7-year annualized deflation was 2.76%.  For 10-years, the annualized deflation was 1.92%.  For 20-years to 1949, the annualized change in CPI was an inflation of 1.82%.

A longer-term CPI chart from 1900 to 2005 from a 2006 PIMCO article provides a comprehensive view of CPI changes:

Implied Inflation in Current TIPS Pricing:

By subtracting the yield of a TIPS of a particular maturity from the yield of an ordinary Treasury bond of the same maturity, you obtain the implied annualized inflation over the time to maturity.

The three tables below show the implied inflation for 5, 7, 10 and 20 years as of January 2, July 27, and December 24 of 2008.

You can see that the implied inflation at the beginning of 2008 was positive, and that it rose to a larger positive number by late July.  However, now it is implying deflation for 7 years, with a minor return to inflation after 10 years, and low inflation for 20 years.

Our Best Guess on Post-Bear Market CPI Changes:

Because of the massive global, multi-national reflationary government programs, we doubt that the 10 years following this bear market will be as deflationary as the 10 years following 1929.  In fact, we are concerned about too much being done too late with consequent post-bear market inflation.

While we may have, or may be about to have, current deflation, it does not seem reasonable to us to project near zero inflation for 7-10 years as seen in current pricing.  We also doubt that annualized inflation will less than 1% over the next 20 years.  If those assumptions are correct, then TIPS would seem a better value today than ordinary Treasury bonds.

Relative Pricing TIPS and Ordinary Treasuries:

The following charts plot the ratio of TIP to IEF. TIP is an ETF investing in TIPS, while IEF is an ETF investing in ordinary Treasury bonds.

They aren’t perfectly aligned in duration, as would be the case with individual TIPS and ordinary Treasuries of the same maturity, but the ETF comparison is a reasonable rough match for relative pricing in this discussion.

The average duration of TIP is 5.67 years, while the average duration of IEF is 6.99 years.

You can see by the sharply reduced ratio since mid-2008 that inflation expectations have dramatically reduced.

Plotting the performance of TIP and IEF separately, they look like this:

TIP versus IEF Weekly for 3 Years

TIP versus IEF Daily for 3 Months

Summary:

TIPS are anticipating no inflation for at least 7 years, minimal inflation for 10 years and low inflation for 20 years.

If inflation occurs, TIPS would appreciate in maturity value and increase in semi-annual interest payments.

If deflation occurs, they would have the same par value at maturity as ordinary Treasuries, but the semi-annual yield would decrease in line with the deflation.

Because we believe inflation is at least somewhat more likely than deflation over the next 5-10 years, and certainly over 20 years, we think TIPS are attractively priced now.

If interest rates rise due to a reduction in fear and a move out of Treasuries into riskier assets, but not due to a measured rise in Consumer Price Index, TIPS would decline in market value, as would ordinary Treasuries.  However, if interest rates rise due, at least in part, to a rise in CPI, TIPS would increase in interest and market value, while ordinary Treasuries would decline in market value with interest amounts remaining constant.

For these reasons, we think investors with a desire to hold Treasury debt, should hold some TIPS as well as ordinary Treasuries (with TIPS in a IRA or other tax deferred, or tax-free account).

That said, 2+% interest, whether real (TIPS) or nominal (ordinary Treasuries) is not attractive for a large portion of most portfolios.

Richard Shaw
QVM Group LLC

First, this is briefly what we said;

“Treasuries have reached bubbly levels, both in terms of low yield and the rate of change of price.

Interest rates will rise when the economy recovers, or when bond buyers demand more long-term interest to absorb trillions of new issues to fund recovery programs. Rising interest rates mean Treasury prices will fall.

… For investors who invest only “long”, closing long positions in long-dated Treasuries, or being alert to a trend reversal necessitating the closing of those positions is recommended.

… For investors who also invest “short”, being alert to a trend reversal creating a shorting opportunity is recommended. The current trend is strongly upward, but could reverse dramatically …”

Some commenters agreed and some did not.

A supportive comment was;

“The safe haven play into Treasuries is demonstrating a true example of a parabolic move. Parabolic moves are unsustainable.”

This amalgam of questioning or counter arguments from commenters is worthy of discussion:

1. there is not yet technical confirmation of a trend reversal
2. shorting now could result in big losses
3. Treasuries are a safe haven play that may persist for a long time
4. the Fed may put a bid under the long bond to keep rates low
5. the Fed said we face “low interest rates for some time”

We have these thoughts about those concerns:

1) We agree there is no technical confirmation of a trend reversal, but sudden parabolic rises may be followed by sudden parabolic declines.  The risk of losses from here due to sudden drops in price (because of diminished fear), even with trailing stops, may be greater than the potential for gain from rates possibly falling further.  The easy money has been made in Treasuries.

2) We agree that shorting long Treasuries now is not justified on a technical basis at this time, although it may be justifiable from a fundamental basis before it is justifiable technically. Our recommendation was and is for short players to be on close alert to a shorting opportunity which may materialize soon — not to short yet — the technicals are still positive, but the fundamentals may be negative — we prefer to be in a position long or short when the technical and fundamental logic is in accord.

3) The safe haven aspect of Treasuries is becoming less certain in the credit default swap markets, which recently had increased the price of default protection for Treasuries by 100 fold.  At some point, questions about the ability of the US to shoulder its newly magnified financial burden, and the prospect of long-term inflation, may cause Treasury buyers to demand higher rates (prices to fall). If rates stay low and at about the same level for a long-time, the recent capital gain aspect of Treasuries will vanish, leaving only an unsatisfactory long-term interest yield.

4) Without completely debasing the currency (which would create high inflation) the Fed cannot buy the bonds needed to be issued by the Treasury.  To make economic sense, new Treasury issuance must be purchased with existing currency held by other countries and other investors, not with IOU’s from the Fed.  The Fed buying from the Treasury, if more than transitory, is an economic illusion.

5) The Fed only controls very short-term inter-bank lending rates.  The markets set all other rates (unless, of course, legislation sets rate limits — what a disaster that would be).

Asset Allocation Implications

For those who do tactical allocation with periodic rebalancing, this is probably a better time than later to lighten up on long-term Treasuries, moving either to shorter maturities to reduce sensitivity to long-term rate changes, or to lower credit quality for higher yield.

As general adherents to the reversion to the mean principle, and having mistakenly ridden bubbles to the top and then back down in prior experience, we are conservative enough to take some profit now and reallocate to other less bubbly opportunities.

Technical View

The long bond is still in an upward trend, but it is getting tired.  That is why we recommend closing positions for those who prefer to take the great middle out of trends without stretching to attempt to catch the very tops and bottoms; or being alert to a possible near-term reversal for those those who prefer to catch as much of a trend after a reversal as possible.  Different strokes for different folks.

30-Year T-Bond Daily for 6 Months with Some Indicators

TLT (ETF long 20+Year Treasuries)

TBT (ETF 2X short 20+ Year Treasuries)

A Look at the Pundits’ Views:

In an unusual market, economic and government intervention situation such as we have, opinions are quite diverse and clearly divided on many issues.

Dec. 25 (International Herald Tribune) –  The U.S. government bond market, which towers above other assets as the only bastion of strong returns this year, could crumble in 2009.

Bloomberg published a general “bubble” statement in a recent lead paragraph;

Dec. 22 (Bloomberg) — The world’s biggest bond investors can’t stop buying Treasuries even though they’re comparing government debt to Internet stocks just before the technology bubble burst.

Let’s look at what some (not all) institutional managers have to say about Treasuries:

Dec. 11 (Bloomberg) — “Treasuries have some bubble characteristics, certainly the Treasury bill does,” said Bill Gross, co-chief investment officer of [PIMCO], which oversees the world’s largest bond fund. “A Treasury bill at zero percent is overvalued. Who could argue with that in terms of the return relative to the risk?” …

David Rosenberg, the chief North American economist at New York-based Merrill Lynch, said last week that demand for Treasuries had reached the “bubble” phase like in technology stocks in 2000 and real estate six years later. …

Another article the same day said;

Dec. 11 (Bloomberg) — The rally in Treasuries that pushed yields on bills below zero percent this week is adding to concerns that the $5.3 trillion market for government debt is a bubble waiting to burst. …

“At some point we are going to get some signal, some indication that this massive policy response is getting some traction,” said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer for Grand Rapids, Michigan-based Fifth Third Asset Management. “The flight out of Treasuries is something that will be breathtaking.”

How long can non-existent returns be acceptable to investors?  Not that long, we would think.

Last week, Jim Rogers said in a 2009 outlook video at Bloomberg;

“[the long bond] is the last bubble left .. it is clearly a bubble”.

Jim Grant was quoted on in Bloomberg for his December 17 statement:

“Government plans to sell $2 trillion of debt … are setting investors up for losses, said James Grant, editor and founder of … Grant’s Interest Rate Observer. … ‘What it speaks to is the illusion that some securities are inherently safe or inherently valuable. … People are piling into Treasuries now … I don’t know what they’re priced for, but they’re not priced for life as I know it in this economy.’ ”

Others, however, see Treasuries differently and more favorably:

Dec. 25 (International Herald Tribune) –  “Either we get deflation or not,” said Jay Mueller, a senior portfolio manager with Wells Capital Management in Milwaukee. “If we get meaningful deflation, Treasuries will still be the place to be. [but] …  if we don’t get the deflation, that will make current Treasury yields look unrealistic and you will do a lot better” in corporate bonds. Mueller put the odds of the U.S. economy skirting sustained deflation at about 60 percent.

Dec. 22 (Bloomberg) –  “There’s probably a little more room for the Treasury market to run,” said Thomas Girard, a money manager who helps oversee $110 billion in fixed-income assets at New York Life Investment Management in New York. “We’ve been very, very gently trying to add some non-Treasury-related holdings into the portfolio, but that’s been a very slow process simply because of the powerful rally in Treasuries.”

… Van Hoisington, president of Hoisington Management, which oversees $4.5 billion, said there is no bubble and that long-term Treasury yields have room to fall. … At a yield of 2.56 percent, a rally to 2 percent in the next 12 months would produce a 13 percent return. …“If you accept the fact the economy’s going to be slow-growing for the next three or four years and inflation in fact is going to zero then it would be a bargain,” Hoisington said.

Long-Bond Prices and Rates As of December 24th:

The bond price plotted in black is shown on the right scale.  The bond yield plotted in red is shown on the left scale.

30-Year T-Bond, Monthly for 19 Years from 1990

30-Year T-Bond, Weekly for 1 Year

30-Year T-Bond, Daily for 3 Months

Most relevant ETFs are TLT (long 20+ year Treasuries) and TBT (2X short 20+ year Treasuries).  Futures can be used to directly target the 30-year bond.

Richard Shaw
QVM Group LLC

Interest rates will rise when the economy recovers, or when bond buyers demand more long-term interest to absorb trillions of new issues to fund recovery programs. Rising interest rates mean Treasury prices will fall.

Consider these charts plotting the interest rate on 10-year  and 30-year Treasuries versus the price of 10-year and 30-year Treasuries. Price and yield are near perfect mirror images.

The 19-year history of the monthly yields shows a steady decline, followed by a precipitous drop in Q4 2008. There is little room for further decline, and reasons to believe that rates must rise. Long-term investors, for example, cannot be expected to be content to earn 2+% forever.

Long-term history of rates shows there is much more room for rates to rise than to fall. We don’t know when rates will rise or by how much.

The Ten-Year T-Bond

The 10-year average interest rate for the 10-year bond is 4.68%, while the current rate is 2.18%.

click images to enlarge

10-Yr T-Bond Yield versus 10-Yr T-Bond Price

Yields are shown as a solid black line. Prices are shown as a dashed red line. The 10-year simple moving average yield is shown as a dashed blue line. The current 10-year average yield is indicated as a green horizontal line. The price range for Treasuries when yields were in the vicinity of the 10-year average yield is bounded by a green oval.

The Thirty-Year T-Bond

The 10-year average rate for the 30-year bond is 5.27%, while the current rate is 2.55%.

30-Yr T-Bond Yield versus 30-Yr T-Bond Price

The charts visually suggest a coming significant fall in the prices of 10-year and of 30-year Treasuries in a mean reversion as general business conditions improve.

Treasury Futures

Futures charts for the 10-year and 30-year bonds tell the same story. The relative strength index (RSI) shows an overbought condition for the 30-year bond and a recently overbought condition for the 10-year bond.

10-Yr T-Bond March ‘09 Futures (with RSI study)

30-Yr T-Bond March ‘09 Futures (with RSI study)

Recommendation:

For investors who invest only “long”, closing long positions in long-dated Treasuries, or being alert to a trend reversal necessitating the closing of those positions is recommended.

For investors who also invest “short”, being alert to a trend reversal creating shorting opportunity is recommended. The current trend is strongly upward, but could reverse dramatically if a Treasury auction brings higher rates. The decline in prices could be as sudden and precipitous as the rise, as the recent gap down in the 10-year futures contract hints.

In either case, whether holding long or short positions, we recommend using persistent trailing stops to minimize the loss potential, while letting profits run.

Investment or Trading Vehicles:

Stock investors can use exchange traded funds.  Futures contracts are available to those with accounts at futures dealers.  There are also Put and Call options traded on some of the Treasury ETFs through stock brokers.  On the long side only, there are low cost mutual funds available.

• Treasuries from 7-10 years are held by the ETF symbol IEF
• Treasuries of 20+ years maturity are held by the ETF symbol TLT
• Treasuries from 5-10 years are held by the MF symbol VFITX
• Treasuries from 15-30 years are held by the MF symbol VUSTX.

IEF has a 3-month average daily volume of 525,000 shares, and TLT has a 3-month average daily volume 2,924,000 shares.

Both may be shorted, but the inventory for shorting TLT is limited, making that impractical to impossible, depending on the broker used.

There are two double-short Treasury ETFs that can be held long to create the economic opportunity of shorting while limiting maximum risk to no more than the invested amount (compared to direct shorting, which in theory could put more than the invested amount at risk).

• PST for Treasuries with maturities of 7-10 years
• TBT for Treasuries with maturities of 20+ years.

PST has a 3-month average daily volume of 133,000 shares, and TBT has a 3-month average daily volume 3,258,000 shares.

Puts and Calls also have the advantage of limiting loss potential to the amount invested, but they are more volatile than the underlying security, and have an expiring time value, as do futures contracts.

* * * * *

INVEST WITH CARE. Seek to reach your return objectives while managing your risk.

Richard Shaw
QVM Group LLC

These discreet fixed length periods may be helpful as you evaluate portfolio weights for US (proxies SPY and IWV), developed market (proxies EFA and VEA) and emerging market (proxies EEM and VWO) equities.

Most performance representations are for X years in the past to the present.  These charts are each 10 years in length beginning January 1st of 1994, 1995, 1996, 1997, 1998 and 1999.

Ten years is often referred to as the period over which everything usually works out (that is not always the case, but it is a good observation period).  We think sequential 10-year periods provide helpful perspective when thinking about allocation between US, other developed and emerging market stocks.

There are only six 10-year intervals to consider, but what titanic shifts they show.

The EAFE index began in 1994.  The Emerging market index began in 1996.  Here are the available 10-year intervals displayed graphically.

This kind of fluctuating and shifting relative performance provides some visual support for the concepts of rebalancing within an asset allocated portfolio, and perhaps for tactical asset allocation within a range of weights are around a target weight for each class.

Rebalancing involves periodically taking money off the table (harvesting) from better performing classes, while adding money to lesser performing classes (planting).  That approach is important to help maintain total portfolio risk level at acceptable and planned levels.

Rebalancing prevents riding bubbles all the way up and then back down.  It also cost averages down for declining classes.

Note: While we subscribe to asset allocation and rebalancing, we took almost all money off the table in July when an unprecedented train wreck for all asset classes appeared to be coming our way.  We now think staging back into ultimate asset allocation positions makes sense.  We’ve been going back into bonds for a couple of months and have recently cautiously put our toe into equities. All of our positions have persistent trailing percentage stop loss orders.  — Note also that many investors have discovered that their risk tolerance is lower than they thought, and will be holding a more balanced mix of stocks and bonds than before 2008.

The shifting relative performance of asset classes may also be the basis for active tactical allocation weight adjustments to capture opportunities, as persistent shifting patterns become obvious.

We think there is a persistent shift of economic growth and wealth from the developed countries to Asia which tactical allocation help might capture.

The way we suggest to most prudently attempt to capture shifting growth and wealth is to allocate core equities in the same proportion that they represent world market-cap, and to adjust those core weights each year as world market weights change.

Note: the world market-cap weighting approach will increase exposure to bubble countries, compared to fixed allocations between countries, but the world has changed much and will change much, making permanent fixed weights obsolete in our view.   Possible bubbles within world market-cap should be examined logically as situations progress.  Rebalancing between equities and fixed income helps reduce the bubble risk.

Core world market-cap can be easily achieved with one, two or three funds - for example:

• One fund: VT (all world)
• Two funds: VTI (US) plus VEU (all world ex US)
• Three funds: VTI (US) plus VEA (developed) plus VWO (emerging)

Note: oddly enough, Canada is missing from the three fund model, but is present in the one and two fund model — MSCI EAFE (non-US developed) excludes Canada.

A more aggressive tactical approach would be to market weight core equity positions, and then tactically add positions to the core that bias the overall weights in the direction of those investment styles, market-cap sizes, regions or countries that you expect to outperform.

Richard Shaw
QVM Group LLC

Certainly, more granularity could be more helpful, but these ten major asset categories are a good place to start.

Categories and Proxy Funds:

* US Stocks (VTI)

* Non-US Developed Market Stocks (EFA)

* Emerging Market Stocks (EEM)

* US Real Assets (VNQ)

* Global Commodities (DJP)

* US Aggregate Bonds (AGG)

* US Treasuries 7-10 Years (IEF)

* US Dollar Index (UUP)

* Crude Oil (USO)

* Gold Bullion (GLD)

Weekly Percentage Performance Charts (2008 as of December 19):

The oil (USO) ETF is plotted with the spot price of West Texas Intermediate Crude to show how close or far from the spot price oil performance the fund performed.

Richard Shaw
QVM Group LLC

When market conditions normalize, it may be reasonable to assume that “scared” money hiding in Treasuries will flow out and into credit bonds.  That would probably cause rates on Treasuries to rise and prices to fall, while causing rates on credit bonds to fall and prices to rise.  However, not much about credit markets on 2008 was as expected, so we’ll just have to wait and see.  Watching the charts may help clarify the situation.

Here are 2008 weekly percentage performance charts for fifteen key types of US and non-US bond index funds:

1-3 Year US Treasuries

3-7 Year US Treasuries

7-10 Year US Treasuries

10-20 Year US Treasuries

20+ Year US Treasuries

Inflation Protected US Treasuries

US GNMA Bonds

US Mortgage-Backed Securities

US National Municipal Bonds

US Investment Grade Corporate Bonds

US Convertible Bonds

US Below Investment Grade (High Yield) Bonds

US Aggregate Bonds
(all excluding muni’s and < 12 mo’s)

Non-US Developed Country Investment Grade Treasuries
(local currency denominated)

Emerging Market Sovereign & Agency Bonds
(USD denominated)

Richard Shaw
QVM Group LLC

Korea has recently been designated as developed by some, but we include it here, because it began the year as emerging and may or may not be universally viewed as developed.

Richard Shaw
QVM Group LLC

• (A) to the yield on 3-month and 2-year US Treasuries,

• (B) to the price of crude oil and gold bullion,

• (C) to the price for the MSCI World ex US stocks index and the Russell 3000 US stocks index.

Relevant proxy securities are UUP or UDN (for Dollar up and Dollar down), SHV (for short-term Treasuries), SHY (for 1-3 year Treasuries), USO (for crude oil), GLD (for gold bullion), VEU (for world ex US stocks) and IWV or VTI (for US stocks).

click image to enlarge

(A) USD to Treasuries

(B) USD to Oil & Gold

(C) USD to US & World ex US Stocks

Crazy Sept-Oct

Here is a 6-month daily chart of the US Dollar index versus the yield on the 3-month and 2-year Treasuries.

In addition to plunging interest rates, the tremendous confusion in the credit markets is reflected in the yield at the short end with the 3-month Treasuries in September and October.

Dollar Bearish

This is a 1-year daily chart of UDN (the inverse of the US Dollar index — Dollar down).

The red horizontal lines show that the Dollar is about half way between its recent highs and lows, but with an apparent tendency to go down (UDN going up).

Once the UDN price goes past the half way point, the trend may become more convincing.  The flooding of Dollars in the many rescue programs makes further declines in the Dollar (and a rise in UDN) more likely than not.

Richard Shaw
QVM Group LLC

FXI, EWJ, VPL, EWH, EWM , EWP, EWL, EWQ, EFA, EIS, VTI, VT, EWG, VGK, EWT, LIS, EWN, EWU, EWI, THD, INP, EWD, EZA, EEM, EWS, ECH, EWW, EWY, EPP, EWA, EWC, EWZ, IRL, IF, EWK, TR, EWO, and RSX.

click image to enlarge

There are numerous articles out about “Dollar Up & Oil Down”, or “Dollar Down & Oil Up”.

Sometimes that inverse movement occurs, and sometimes it does not.  When the inverse correlation is working, there may be a trade, but when it is not, find something else to do.

Here is an 18-year monthly chart comparing the US Dollar (proxy UUP) to West Texas Intermediate Crude (proxy USO).  You can see inverse correlation sometimes and not at other times.

The red line is for the US Dollar Index (USD against a trade weighted basket of currencies).  The black line is the spot price of crude.

There is substantial argument today that the Dollar will fall due to all of the debt issuance associated with the economic rescue programs.   There are also strong voices saying that oil will rebound to perhaps $70+ when economies improve, based on the average deep sea finding and lifting cost. That would suggest an inverse chart correlation may exist in the future, but the causation is not described as the same for each.  Any future correlation may be partly coincidental and partly cause and effect.

It is not safe to assume that if one rises the other will necessarily fall.  You must stay on your toes, or lose your toes, and maybe some fingers too.  Remember that a big part of making money, is not losing money.  Acting on false assumption about structural price relationships is one good way to lose money.

Richard Shaw
QVM Group LLC

Categories and Proxy Funds:

• US Stocks (VTI)
• Non-US Developed Market Stocks (EFA)
• Emerging Market Stocks (EEM)
• US Real Assets (VNQ)
• Global Commodities (DJP)
• US Aggregate Bonds (AGG)
• US Treasuries 7-10 Years (IEF)
• US Dollar Index (UUP)
• Crude Oil (USO)
• Gold Bullion (GLD)

click images to enlarge

charts provided courtesy of www.StockCharts.com