Hi Guys,
Several weeks ago, I posted a summary of my six-factor Recession Equity Adjustment Model (REAM). The purpose of that model is to facilitate my decision-making with regard to portfolio asset allocations based on macroeconomic considerations.
When the investment waters are more calm, I typically only evaluate that model about once a month; in the more turbulent current market environment I have taken to scoring that model on a weekly basis.
You may recall that many of the metrics that I use in that model are bond/interest rate related. During my most recent update of the required model data inputs, I finally recognized what poor investment returns long-term bonds are presently delivering. For example, the 10-year treasury is presently issued at an annual rate of only 2.94 %; that’s well below the US inflation rate of 3.6 % reported in Monday’s edition of the WSJ.
The whole Bond market is upside-down. I remember Bill Gross pontificating in his 1997 book “Everything You’ve Heard About Investing is Wrong” that a private investor should not commit to long duration bonds unless yields exceed 7 %.
I believe that this wizards generic rule is far too simplistic. Interest rates must be tied to inflation rate expectations. Here are a few of my simple rules of thumb which are grounded in historical bond market returns. Bond vigilantes operate to keep prices and yields in pretty good order.
Long-term US treasuries, like its 10-year product, should incorporate the assumed zero risk 3-month bill rate plus anticipated inflation rate plus about 1.5 % as a reward for spending postponement. In today’s environment, that formula calculates to a 5.15 % annual return. The government’s 10-year treasury is only providing a dismal 2.94 % which doesn’t even cover inflation.
Again, based on historical data sets, high grade corporate bonds should produce a minimum of 0.5 % to 1 % annual return above government entities to compensate perceived (and real) increased default risk. The current crop of corporate bond entries also fail in this regard.
Although very late in its arrival, this finding came as an epiphany to me. Sorry for my tardiness in recognizing the obvious.
I guess that’s why my portfolio’s present bond holdings are focused on very short-term, low cost products, inflation protected TIPs, and a few intermediate-term bond funds.
As I mentioned earlier, I now evaluate my six-factor REAM model weekly. As of last Monday, all six components generated green signals. That means I need not reduce my equity asset allocation at this time.
In my final interpretation of the six factor metrics, I classify each of these factors (Fiscal, Momentum, Valuation, Macroeconomic, Liquidity, and Sentiment) into 4 colors: dark green, light green, yellow, and red. Obviously, the dark green means keep my equity positions, while the red directs an immediate conversion to fixed income holdings. The light green means that I need to increase my vigilance since the signaling metric is moving in a dangerous direction. The yellow means that I crossed a threshold, so I wait a few days longer to secure confirmation of the crossing.
My Fiscal, Valuation, Liquidity, and Sentiment indicators are solidly in the dark green arena for now; that gives me comfort. However, both the weekly updated Momentum and the quarterly updated Macroeconomic indicators are presently in the light green zone and command more diligent watching.
Although still positive, the Momentum signal (the relative value of the 65-day S&P 500 Index moving average compared to its 200-day equivalent) is converging towards a crossing penetration that informs me that a partial exiting (like 15 %) of my equity mutual fund holdings is prudent.
The revised real GDP growth rate from the Bureau of Economic Analysis (BEA) for the first quarter of 2011 is only at the puny 1.8 % annual rate. Since population demographics require at least a 1 % growth rate to maintain our standard of living, I am very antsy about our muted real GDP progress. I recently downgraded this factor from a dark green to a light green. I am dubious with respect to our economic emergence from its doldrums and its uncertain trending survival from our recession.
I surely do not know what the equity marketplace will register in the next six months, but my model is still positive, although it is presently slipping just a little. The marketplace warrants careful scrutiny and a watchful eye at this juncture.
Coupled with the statistical prospects from the generous third-year returns of the Presidential market cycle, I remain at my 50/50 equity/fixed income portfolio mix for now.
I wish all of us good fortune and good luck in the current stormy financial marketplace.
Best Regards.
Comments
Thank you for your take on the market(s) and your current positioning. Acknowledged, your process is much more scientific than mine. However, we are both now at about 50% equities and I am probally lighter in fixed than you at 25% but heavier in cash (25%), which includes what is left of my CD ladder as I have rolled out of my CDs as they mature due to current low interst rates, than you.
Thanks again.
Have a good evening ...
Skeeter
As we can no longer perform a direct reply to the original post; I will piggyback at Skeeter's reply. And Hi to you, too, Skeeter.
Do'in this the old FA way in reply to "some" sections of your post. I'll do my best quick and dirty, and I don't have facts for support; only a few brief looks at some fund numbers and shoot'in from the investment hip.
"Several weeks ago, I posted a summary of my six-factor Recession Equity Adjustment Model (REAM). The purpose of that model is to facilitate my decision-making with regard to portfolio asset allocations based on macroeconomic considerations."
"When the investment waters are more calm, I typically only evaluate that model about once a month; in the more turbulent current market environment I have taken to scoring that model on a weekly basis."
Catch >>>>>Not that this matters to this discussion; but I always look once a week; as at times one is able to get a feel where a manager may have shifted some investment sectors, that are only known for the 1st day to be valid, after publishing the most recent prospectus. At least this sometimes seems to apply to multi-sector bond funds.
You may recall that many of the metrics that I use in that model are bond/interest rate related. During my most recent update of the required model data inputs, I finally recognized what poor investment returns long-term bonds are presently delivering. For example, the 10-year treasury is presently issued at an annual rate of only 2.94 %; that’s well below the US inflation rate of 3.6 % reported in Monday’s edition of the WSJ.
The whole Bond market is upside-down. I remember Bill Gross pontificating in his 1997 book “Everything You’ve Heard About Investing is Wrong” that a private investor should not commit to long duration bonds unless yields exceed 7 %.
I believe that this wizards generic rule is far too simplistic. Interest rates must be tied to inflation rate expectations. Here are a few of my simple rules of thumb which are grounded in historical bond market returns. Bond vigilantes operate to keep prices and yields in pretty good order.
Long-term US treasuries, like its 10-year product, should incorporate the assumed zero risk 3-month bill rate plus anticipated inflation rate plus about 1.5 % as a reward for spending postponement. In today’s environment, that formula calculates to a 5.15 % annual return. The government’s 10-year treasury is only providing a dismal 2.94 % which doesn’t even cover inflation.
Again, based on historical data sets, high grade corporate bonds should produce a minimum of 0.5 % to 1 % annual return above government entities to compensate perceived (and real) increased default risk. The current crop of corporate bond entries also fail in this regard.
Although very late in its arrival, this finding came as an epiphany to me. Sorry for my tardiness in recognizing the obvious.
I guess that’s why my portfolio’s present bond holdings are focused on very short-term, low cost products, inflation protected TIPs, and a few intermediate-term bond funds.
Catch >>>>>Per the above regard to the yield of a single gov't bond or corp. bond, too that is at 2.94%; and could also apply to a "fund" of such issues with the combined same yield. You only note a yield amount, but nothing related to whether a given bond or bond fund have an increase or decrease in the value of the bond(s). The best I will be able to do with limited time tonight is to note that our bond fund holdings, with the exception of HY/HI are not solely driven by a yield, but with regard that other investors may continue to allocate monies to the bond area and thus drive the value/NAV higher. This is were we look for growth, too; not just a yield. I will relate this thinking is really not unlike one buying an equity/income/dividend fund that may also have a yield of 2.94%. IF by magic, a gov't bond fund and an equity income fund both have a yield of 2.94% and the underlying demand for either area is sideways and of little interest to investors, the effective NAV of these funds could remain static/sideways and in the end niether would have a greater benefit of positive return in total. Now, if one area has more demand going forward, obviously that fund/sector will move ahead for one's returns.
If I held 25% in each of these "magic" funds today and sitting on 50% cash; I would have to continue to evaluate which of these may have favor with the investment world in the next 6 months and invest more monies in that fund area. Will monetary policy and/or the consumer cause a slow growth forward OR just plain sideways OR the greatest fear I believe of Mr. Bernanke....deflation. A most serious economic position from which to become "unstuck".
I have only compared active managed funds of a 20+year Treasury style with an equity income style, both of which may throw off a similar yield over a given time frame and both would also have a similar chance to provide a return in the underlying value of the issues within the funds; both fund types likely traveling in opposite directions at a particular market cycle, but also having the own chance to "shine".
I quickly peeked at a few 5 year returns of these two funds types and found very few of the E.I. type that performed better than named "long term" bond funds.
Only the rearview investment mirror will reveal the winners.
"Coupled with the statistical prospects from the generous third-year returns of the Presidential market cycle, I remain at my 50/50 equity/fixed income portfolio mix for now."
>>>>>I have not concluded that any current cycle may prove to be able to rest on the recent histories of statistical adventures. There is indeed a new normal; if only in a sense of the length of time for events to unfold and be accepted by those who form the rules and laws of the county; and how the public consumer or investors chooses to react to or accept any and all changes that are still taking place at this moment.
I write this much too late at the end of a busy day; and hope there is a state of sense to some of the words, and that they may actually be readable as a small, total thought as to how I view the comparisons above. Perhaps this late hour has caused the intended meaning to become distorted or perverted.
A few last pinches of spice to this stew pot of words. I see an equal chance that the 10 year Treasury may travel to 2.55%, before traveling to 3.55%. Just call me crazy, eh? Also, the world still travels to Treasuries, which is also of benefit to the TIPS bonds; during the strange periods; and not so much to the U.S. dollar as has been in previous periods. Yes, strange days have found us.
I have chosen not to reread or proofread the text tonight.
Thank you MJG, for helping keep the brain cells in process mode.
Regards,
Catch
Thanks for helping Catch. He's a great participant in this forum.
I don't invest in the Junk category of mutual fund so I have not studied papers on that topic; Catch would likely have more definitive info and opinions on Junk bonds.
I suspect there might not be a simple answer to your question because of the many varieties of Junk bonds that are packaged together in funds.
For the higher grade Junk products I would expect an increment of at least 2 % above high grade corporate products. For the lower grade Junk products (Junk-squared), I would require an expected return that approached equity return levels. This estimate is based on a weak memory that I have of a position that Bill Gross advocated several years ago.
The Forum has many more better qualified participants than me to properly respond to your excellent question. Buzz them.
Best Wishes.
" If you use the reply box at the end of the page, you are posting a direct reply to the original poster. You do not need to piggy-back onto another reply. (In other words, do not search for reply link. Go directly to the bottom of the page) >/b>"
>>>>>Bottom of page??? I do not find a reply button, other than associated on the same line as a poster's name.
Take care,
Catch
I have tried to model my portfolio in my mind as well as on paper. My first step in the process was and is to select my investments. This is the work...the learning curve that continue throughout my investing life. I will call these investment choices my balloons. My core balloons were and are my first set of balloons. As a younger investor I chose a balanced fund as the core balloon. As I now consider myself an older investor I have a set of core balloons that provide income, dividends, and risk protection. But, whatever your core is, remember they are your all weather position or positions.
During the accumulation stage of life I inflated this core with some of my own money as well as with "overinflated" winning from my other "balloons" in my portfolio. To picture my portfolio in my simple mind I imagine these "core balloons" having many valves that are interconnected with other portfolio positions (balloons). All investment connect back to these core balloons. They each can open and close accepting new money or shedding off overinflated profits. This mental image of balloons helps to remind me to take profits often but not to deflate a position I still believe in or more importantly Mr. Market still favors.
This image of balloons also reminds me that, at certain times, some balloons may need a short steady burst of "air". My "core balloons" provides that method of reflation. Hopefully I am reflating at a time when the value of that investment is out of favor and therefore a bit of a bargain...again, "buying bargain" is just as important as "selling profits"...doing this often helps to remove some of the volatility of the market and grow my portfolio.
I am a market participate and therefore I will always have core positions that I believe in at all points along the market cycle. In this environment of low interest rates a cash alternative position can be hard to find as well as a compromise to the instant liquidity of cash. My investment balloons, whether they are core or not have been selected because I perceive good management and future market opportunities. The decisions I make regarding which funds to own are based on the dynamic of me learning how to "monitor yet trust"...."trust but verify".
If our congress and regulators had only followed these simple rules things might be very different today financially speaking.
When the market retreats below its 200 dma (which is where the S&P 500 is right now) I try to discipline myself to change course...to return to my core. I try to base new decision on the evaluation of yesterday's actions and the condition of today's landscape.
Thanks to all of you here in helping me form some of my decisions.
Thanks for your visually stimulating submittal. The imagery you created is superb; it helps to crystallize your investment approach in a concise and understandable manner. Investing need be only as complex as we allow it to be.
I suspect your balloon symbolisms will help other Forum members when making their portfolio decisions.
Here’s wishing that all your balloons and those of our Forum participants will continue to expand and to rise; the higher, the better.
Good luck to all of us in these tumultuous times. Simplified models grant us discipline and give us something to trust when the storms arrive.