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Friday, August 13, 2010

I Was Just Noticing....

....that in the spring when the headlines were full of the crises in spain italy and greece some (including our friend James B Stewart of the WSJ) were recommending confining one's holdings to Germany rather than all of Europe to avoid exposure to further financial crises.. Of course the fact that Germany was among the biggest losers in the early stages of the crisis didn't exactly argue in favor of the strategy. It didn't turn out to accomplish much as european stocks recovered this summer either. Here's IEV (europe) vs EWG (germany)

Thursday, August 12, 2010

If TIPs are such a bad investment in a deflationary environment why does that TIP keep going up ?

If tips are such a bad portfolio holding under deflation why have they done so well  recently when the coming deflation is the new "market consensus" ?

Earlier in the year with the conventional wisdom predicting inflation and higher interest rates many went 'all in" and positioned themselves aggressively to profit from higher interest rates. As the WSJ reports it didnt work out too well:
Betting against Treasury bonds was supposed to be the no-brainer strategy for 2010. Instead, shorting government debt has brought steep losses so far this year, due to surging bond prices as investors seek safety on worries that stocks could be hit by deflationary headwinds. The largest exchange-traded fund tracking the long end of the Treasury curve, the $3.3 billion iShares Barclays 20+ Year Treasury Bond Fund (trading symbol TLT), has rallied more than 10% year to date.
The largest exchange-traded fund tracking the long end of the Treasury curve has rallied more than 10% so far this year.
At the same time, a leveraged ETF designed to profit from falling Treasury prices, ProShares UltraShort 20+ Year Treasury (TBT), has lost more than a quarter of its value as yields have ticked steadily lower—bond prices and yields move in opposite directions.
Now that the conventional wisdom has done its 360 degree swing the crowd of advisors and advice givers is now positioning for the now "certain" deflation. Some of the advice risky, pushing portfolios into a position that will get burned badly if this "consensus forecast"(once again) proves icnorrect and (once again) the "no brainer" portfolio moves turn out(once gain) to be big losers. One interesting part of this poor portfolio advice is a simplistic evaluation of the role of tips in a portfolio anticipating deflation.

From the wsj:(my bolds my comments in blue)

How to Beat Deflation

Strategies to protect your portfolio from—and take advantage of—the dreaded 'D' word.

Bond-fund manager Jeffrey Gundlach—who thinks yields on the 10-year Treasury note could fall to 2%—has about 40% of the DoubleLine Total Return Bond Fund's assets in longer-term government debt, such as Ginnie Mae securities. If yields on 10-year Treasurys fall to 2% within a year, investors could reap total returns of 10% to 12% as the price of the securities jump, he says.
Zero-coupon Treasury bonds, known as strips, can provide the best protection, since the fixed rates are locked in and automatically reinvested at the fixed rate, says Troy Von Haefen, a financial adviser in Nashville, Tenn., who primarily uses Treasury strips as a deflation hedge and holds them to maturity.

The above positions will no doubt benefit greatly if long term interests rates fall further. Mr. Gundlach seems to be acticipating that the ten year bond yield will drop within a yea by almost  1/3 from its current 2.95% to 2% (!). It is also certainly true that longer term zero coupon bonds benefit most from lower rates(their duration = their maturity). It is also true that concentrating ones portfolio in this manner is a huge and risky bet on lower interest rates at a time when they are at their lowest levels in over a year.and two year bond yields near record lows. Perhaps another "no brainer" that won't work ?

Then there is the view expressed below on tips which seems also part of the conventional wisdom and is misguided:

Conversely, inflation-linked securities such as TIPS (Treasury inflation-protected securities) and I Bonds (inflation-linked savings bonds) could lose value in a period of sustained deflation. When the consumer price index turned negative in 2009, for example, rates on I Bonds temporarily dropped to 0%. Investors could see the value of their TIPS decline, since any negative change in the CPI would be applied to TIPS' principal, reducing the interest earned. (If investors buy TIPS at auction and hold the bonds until maturity, the Treasury pays the inflation-adjusted principal or the original principal, whichever is greater.)

Lots of confusion in the above paragraph. First off the "analysis" confuses price with yield

The price if a tips bond (and the tips etf) is reflective of the real yield on the tips in one's portfolio compared to the market real yield of tips.Price moves inversely to yield just like for regular bonds except for tips it is the real yield not the nominal yield that determines the price. When inflation expectations fall, real yields on the tips go down and the prices go up. The current real yield on the 10 year tip is around 1.1%. That explains the price appreciation in the tips etf in the chart  below. The fact that i bond yields (not the same as ibonds btw since ibonds are not a tradeable  instrument) went to 0% at one point is interesting but not particularly relevant. It also means that someone holding an inflation protected bond with a 1% real yield would reap a considerable capital gain in the unlikely event that tip yields hit zero.

Last month, Janet Briaud, a financial adviser in Bryan, Texas, sold her clients' holdings in TIPS, parked the proceeds in cash and has been putting as much as 20% of clients' money in long-term government bonds. "If markets come down over the next 18 months, we expect that investors will go to the safe haven of Treasury bonds," she says. 

Now here is a risky move that could turn out ugly with a little confusion thrown in as well. 
This advisor has gone "all in" with a massive and risky bet on long term interest rates falling when she already held a tips position that would likely give her considerable gains in the event of lower inflation with considerably less risk.

Take a look at the chart below It shows the long term treasury etf vs the tips etf. As can be seen the tip has held increased in value as inflation expectations have fallen and has been far less volatilie.
Long term treasury etf (tlt) vs TIP etf (TIP)


intermediate term treas eft (ite) v tip
.Perhaps even more interesting is this second chart which is the intermediate term treasury etf (ite) vs the  TIP etf.. Both etfs have approximately the same maturity. The two are extremely highly correlated (except for the bad data point in december 2009) and in fact the tip has benefitted more than the conventional bond from the recent rise in deflationary expectations.

Why would that be the case ? because as noted the price of tips moves inversely to moves in real yields, which like nominal yields move up and down in response to inflation expectations.If  inflation expectations godown prices of both nominal bonds and tips go up. 

Conversely of course if the conventional wisdom proves wrong and inflation expectations shift real and nominal yields will go up and the prices on tips and conventional bonds will go down.

But here's the really interesting argument for not dumping that tips position: The tips include an imbedded "option" on inflation. Should inflation go up the downside risk on the price of the inflation protected bond is reduced unlike that of conventional bonds.

Althought the tips position will gain from a market that anticipates deflation/low inflation it is a far less risky position than one that abandons tips for a long conventional 20 year treasury position. Why is that the case ?
should that "sure thing" not occur and we get inflation and not deflation it will certainly be the case that the rise in real rates will hurt the tips. But unlike the conventional bonds the tips have a built in hedge. The return on the tips consists of the coupon rate based on the locked in real yield+ an inflation adjustment the tips holder gets additional cash flow in the form of the inflation adjustment should inflation occur.

An increase in inflation expectations will hit the tips holder less than the conventional bond holder. The tips holder gains on the deflationary expectations, is hurt less than the conventional bond holder when inflationary expectations go up and gets an increase in his cash flow should actual actual inflation occur (unlike of course the holder of conventional bonds). In effect the tips position has a "long inflation put".due to its inflation insurance feature as we know long options positions are effectively insurance.

On the other hand that advisor who dumped her treasuries for long term treasuries will find her clients with greater losses since they get only the low coupon rate with no inflation adjustment. On a price and mark to market basis the losses on the conventional treasuries will be far greater. So as a trade/portfolio readjustment this advisor has definitely increased the risk of the portfolio by abandoning tips for long term treasuries She increased the risk if she is wrong and marginally increased the return if she is right.

From the point of view of a long term position the logic seems even weaker. With 10 year tips at a real yield of around 1.1% and then year treasury bonds at around 2.95% replacing tips with conventional treasuries means that inflation will have to remain below 1.85% over the life of the bond for the position to prove attractive. This is the implied inflation forecast in the treasury/tips yield curve. Historically an implied inflation forecast like this imbedded in the treasury/tips differential has been considered  a buy rather than a sell signal.for tips.

Whether from a long term  or a shorter term "tactical' portfolio positioning it seems that dumping tips in favor of long term treasuries might well be following the conventional wisdom into a risky "no brainer' trade that may prove quite constly. It certainly seems based on an incomplete understanding of tips.

As for the advisors comment about

safe haven of Treasury bonds,

with reference to tips and conventional treasuries of course that is a non issue the "safe haven" aspect refers to bond being backed by the full faith and credit of the us govt and of course both tips and convnetional treasury bonds are the same in this repspect.


Wednesday, August 11, 2010

No surprise here..

from the FT

Consumers in developing countries more confident

By Daniel Pimlott in London
Published: August 10 2010 16:59 | Last updated: August 10 2010 16:59
Consumers in major developing countries are massively more confident about the state of their economies than their counterparts in western Europe and the US, according to an opinion poll that lays bare the two-paced nature of the global recovery.
In India 85 per cent of consumers see their country’s economic situation as good, while 77 per cent of people in China and 65 per cent in Brazil are also positive about their economies.
However, in Spain just 5 per cent view their economic situation positively, in France 6 per cent, in the UK 13 per cent and the US 18 per cent, according to a survey of 19,000 citizens in 24 countries by Ipsos Mori.
The gulf between the major developing economies, which have grown robustly out of the downturn, and many of the major developed nations, which have continued to battle fears of renewed recession and sovereign debt problems, underlines the sense of an emerging new world order in the aftermath of the financial crisis....

The weakness in confidence in western Europe and the US appears to have deepened this year as fears of fresh crisis have emerged over sovereign debt problems.

Tuesday, August 10, 2010

Morningstar Finally Tells Us What Those Star Ratings Are(n't) Good For

The Wsj reports on a morningstar study that answers that question:

Low Fees Outshine Fund Star System

Low fees are likely to be the best predictor of a mutual fund's future success, according to a new study by Morningstar Inc.
The study, to be released Monday, shows that using low fees as a guide would give investors better results than even Morningstar's own star-rating system, which looks at past risk- and load-adjusted returns. While the stars system has typically guided investors to better results, it isn't as effective in predicting future returns at times of big market swings.

Low-cost funds performed better on average than high-cost funds, Morningstar found.
Morningstar found that in aggregate, low-cost funds had better returns than high-cost funds across all asset classes, during various periods from 2005 through March 2010.
Fees "have proven to be the strongest predictor out there." says Russel Kinnel, director of fund research and author of the study. "The stars system, as a measure of past risk-adjusted performance, is going to be a little more limited."
That said I think morningstar does a great job of putting together data on mutual funds, coveing the mutual fund and etf industry and providing analysis of personal finance issues. Just dont use its ratings or recommendations in choosing a mutual funds. Of course if you take morningstar's own study to heart the ratings on actively managed funds will be irrelevant anyway as you will just be choosing from among index funds and etfs.

Thursday, August 5, 2010

He's One of the First with Personal investment Advice on Dealing with Deflation...and He's Mostly Wrong

With the conventional wisdom now firmly rooted in the deflation camp having made a 360 in a matter of months, there will be doubtless a flood of personal finance articles on how to cope with the coming deflation. Many of those articles will be in the same publications and even by the same authors as the "inflation is coming here's how to cope articles.".

One of the first out of the box with this is James B Stewart whose investment advice I reviewed in an earlier post. He doesnt do much better on this subject although he claims otherwise despite the clear evidence that goes the other way.

so how should individual investors protect themselves from even a small risk of deflation? If you have been reading and acting on this column, you already are well on your way. Back in February, when inflation fears were widespread, I wrote a column with a strategy for lower inflation and rising interest rates. I thought the Fed would be raising rates by now, which would lower inflation expectations.Inflation worries have all but disappeared, which means that advice proved sound. But not for the reason I expected. Interest rates haven't gone up—they're even lower—and they don't seem likely to rise soon. That environment requires some further adjustments.
In February, I urged investors to reduce exposure to traditional inflation hedges such as gold, commodities, energy and Treasury Inflation-Protected Securities. Gold, precious metals and oil prices are off their peaks, but investors should continue to avoid them.
Deflation is an ideal environment for high-quality fixed-income assets because the value of the income stream rises as prices drop. In February I urged fixed-income investors to shorten maturities. That meant moving into higher-quality bonds, such as investment-grade corporate and Treasurys, as well as federally-guaranteed bank certificates of deposit. To protect against deflation, investors should maintain the focus on high quality, but lengthen maturities. This is easily implemented as short-term bonds and CDs mature. There also is nothing wrong with holding cash or cash equivalents, even with money-fund rates close to zero. Cash gains in value as prices fall.
The trouble is the advice in February was dead wrong in fact he miised an enormous rally in long term bonds as long term interest rates dropped sharply (see chart of tlt the long tern treasury etf lower yields=higher prices. His recommendationn was shorter maturities the short term treasury bond etf (shy)was +.07% the long term t bond etf (tlt, chart below ) +11%.

As for his advice to avoid commodities and tips didnt do to well either :
energy (dbe) unchanged
gold (gld) +10%
tips +2.5%

Mr Stewart now has switched his view on bonds to lengthen materials but holds onto the other view.

Where did he go wrong on this and why may that continue to be the case:
TIPS logically would go down in value with views of low inftion but in deflation but the story is more complicated you cannot lose principal even if there is cumulative deflation over the life of the bond (not too likely for longer maturities. So in fact the tips have a bit of a deflation hedge. You cant lose prinicpal and with rates so low even if  inflation is zero you would do better than investing in short maturities in the current environment unlike locking in long maturies if inflation reemerges you benefit while the long bond holder suffers losses.

In the commodity area Stewart misses the point that the deflation threat is most significant in the developed world. The developing world is still growing and has large needs for commodities. Commodities have a mixed record as an inflation hedge and likely some would rally in a deflationary environment due to supply/demand factors.from emerging market demand. In fact just as the conventional wisdom has shifted to deflation forecast, wheat has rallied significantly. Below is the chart for the agriculture etf (dba).

So really the most reliable advice in light of an inflation forecast is to lengthen which Mr. Stewart has finally come around to. Others have been aggressively acting in anticipation in months not only buying long term bond but even more aggressively buying"stripped treasury bonds or the zero coupon bonds which are most sensitive to interest rates change and return large gains in the current environment.

Wednesday, August 4, 2010

Those Low Treasury May Not Be So Irrational.

...Certainly with the new conventional wisdom decidedly in the deflation camp (as reported in the wsj).

That's in contrast with the warnings of high inflation that reflected conventional wisdom as recently as a few months ago because the fed was "flooding" the markets wtih liquidity. . As I pointed out then those folks should have reviewed their Friedman (the nobel prize winning economist stuff not the social criticicism. If they did they would know that if money supply is increased but there is no velocity (i.e. the money isnt let out. There will be no inflation. Keynes was aware of this too of course he coined the phrase pushing on a string. No wonder the fed is examining alternative ways to use monetary policy to stimulate the economy.

So if the treasury market is trading off a forecast of zero inflation or even deflation that 2.88% level on the 30 year bond doesn't look crazy for traders even if it would be a not very good purchase to put in the drawer for 30 years. A reasonable long term expectation fot the long bond is around 3% above inflation so the current yield is in line with historical rates.

Unortunately the low yields don't bode well for stocks, at least using one common methodology. Those that "bootstap" a long term forecast for stock returns a common academic finance approach  use  a long term risk premium for stocks (the compesation for taking on the additional risk of stocks) as 3 -4% over the risk free rate. That risk free rate could be the tbill rate of .16% or perhaps the 2 year note rate of .51%. That puts the expectation for stocks in the 3.5% to 4% range purely as a function of the current low level of interest rates.