Peaking Bond Markets: The Reversal of a 30 Year Trend

Is the three decade long bull market in bonds over?  It certainly seems that way.  Bonds have been retreating across-the-board since early November.  QE 2, which was supposed to bring rates down, simply isn't enough -- even in the targeted middle range of the yield curve.

So what happened in early November?  I don't know. Maybe it was the announcement of QE 2.  Look at Vanguards Total Market ETF: BND.




Consider:

• Treasuries are in an downtrend across the spectrum:  See the 2 year here, the 5 year here, the 10 year here, and the 30 year here.  All show declines after early November peaks. The benchmark 10 year in particular shows an alarming drop.
• Municipals suddenly collapsed  and show no sign of recovery.  PCK, a leveraged California Closed End Municipal fund is down almost 20% since November 7.
• Corporates (LQD) mirror the declines.  Surprisingly, junk bonds (JNK) have held up somewhat better.
• Emerging Markets (EMB) are not immune.

Pundits have long touted the debasement of the U.S. dollar but now the unease is spreading.   Perhaps last month's precipitous drop in munis was a wake-up call.  It will take a lot to change the public's view of bonds as a "safe" investment, but that may now be starting.

The Fed seems to be losing control.  Former Fed Reserve Chairman Alan Greenspan warns that on going deficits will lead to a bond crisis.   Mr Bernanke is between a rock and a hard place.  Tightening may crash markets.  But . . . QE contributes to the perception (reality?) of dollar debasement -- driving interest rates up anyway.  To make matters worse, QE's newly printed dollars flee U.S. shores, contributing to overseas inflation which may precipitate currency wars.

All fixed income instruments will follow treasuries down if rates rise.  You may find a possible haven in convertible bonds.  Blue-chip, dividend paying, stocks may be your best bet for a "safe" investment from here on out. Do your own due diligence.

The bond market is huge ($91 trillion worldwide) -- more than twice the size of equity markets.  If prices continue to decline, some this money will flow into equities and commodities, pushing up inflation.  Commodities are arguably in a bubble while blue-chips are probably not (yet).  Once inflation gets started, it is very difficult to stop. You can argue over what is inflation but precise definitions of inflation are meaningless to most people.  If the price of fuel goes up . . . it is inflation to them -- even if wages are stagnant or falling.

Keep an eye on the Fed.  It seems QE is needed on a ongoing basis to prop up the economy.  At the slightest sign of tightening (such as the pending expiration of the Build America Bond program) markets head south fast.  Bernanke says he is not going to allow deflation, yet the Fed has to pump harder and harder just to stay even.

The ground world economies are standing on is getting steadily narrower, sooner or later we will fall either into the pit of deflation or the excesses of inflation.  Either way it won't be fun.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours

Are Municipal Bonds Cracking?

Look at last week's price action in PIMCO's Municipal Income Fund ETF (PML).  Municipal bond markets plunged.  Not surprisingly, the California ETF (PCK) shows the most precipitous drop.

It might be argued that muni markets are merely reflecting similar declines in treasuries (TLT).  Fair enough. Bond holders, though, are probably are more interested in the fact that their bonds have declined rather than why they are declining.

Warren Buffet warned back in June on the Muni Bond market. Defalt, so far, have been rare but local and State municipalities are struggling to meet their obligations.

There was a time -- before the 2008 crash -- when triple AAA rated, insured munis were seen as the safest of safe investments.  Times have changed.  Only Assured Guarantee (AGO) still insures municipals but the company has been recently downgraded from AAA to AA.  Ambac (AMBK) is  in bankruptcy. MBIA (MBI) is entangled in litigation and no longer writes new policies.  The financial guarantee business today is but a shadow of its past.

Even though defaults in the muni markets have been rare so far the Feds zero interest rate policy has thrown a cloud of uncertainty over all bond markets.  Declining tax revenues, rating downgrades, loss of insurance, rumors of bailouts, all contribute to uncertainity and suspicion that all is not as well as claimed.

It may be wise lighten up on all medium to long term bonds at this juncture.  Greece, Ireland and Portugal may not be as far removed from New York, Illinois, and California as we might wish.

QE2 or the Titanic?

Someone has awaken the band, found the girls, and broken out the drinks!  Thanks to Ben Bernanke's Quantitive Easing 2 (QE2) November 3rd announcement the risk asset party is in full swing again.

The Fed's planned purchase of $600 billion in Treasuries and QE1 rollovers over the next 8 months already has it fleeing into equities, commodities, and emerging markets -- before the QE even starts!
The elections put Congress out of the stimulus business.   Not to worry . . . .  The Fed's QE2 ship, captained by Mr. Bernanke, is launched and steaming off into dark, uncharted waters -- with or without congressional support.
Since the U.S. dollar is the world's reserve currency, you might say Mr. Bernanke is Captain of the World.  Worldwide FOREX, bond, equity and commodity markets all soar or fall on the slightest nuances from him.  To argue if it right for one man to have so much power is, at this point, moot.  He simply has it.
Who wins with QE?

• Banks:  They get liquidity and more time to repair their balance sheets.  The interest free money is reinvested where it earns more (rate arbitration -- profits come from the spread).  Why risk loans to the private sector when you get a risk free return from Uncle Sam?  According to Shahien Nasirpour in the Huffington Post U.S. banks own $1.6 trillion in taxpayer-backed assets such as Treasuries and Fannie and Freddie debt.
• Some of the public:  Rising markets benefit those who have the foresight be invested in them.  The hope, of course, is that inflating asset values will eventually spread to the increasingly desperate real estate sector.  No sign of that happening yet though.
• Corporations:  They are floating bond issues while interest rates are low -- get while the getting is good.  The stock market recognizes this and is rising.  High unemployment allows corporations to keep wages low and employees working on over drive.

Who loses with QE?

• Savers and other frugal people:  Interest rates are at record lows.  I didn't even bother listing the $2 interest income I made last year from a savings account.  The Fed is forcing us into risk assets and anyone who holds cash in U.S. dollars or cash equivalents such as treasuries loses.  If bond markets crack and interest rates skyrocket (as they will if inflation picks up) anyone holding fixed income denominated in U.S. dollars takes big losses.
• The U.S.:  Dollar devaluation sparks up commodity prices and exports inflation world-wide.  The recession stricken U.S., however, does not have the room to increase wages to compensate increasing fuel and food prices.  You already see the signs -- more people walking or bicycling (that may actually be good), more gardens, more roadside produce stands, empty malls, shuttered businesses, large numbers of homeless, etc.  The bottom line: One way or another, the U.S. standard of living is declining.

Other QE risks.

• Currency war:  QE in the U.S. raises all kinds of red flags abroad.  Both European and Japanese Central Banks may be forced to intervene (retaliate?), precipitating a "currency race to the bottom".  No wonder precious metals seem to be rising nonstop --  a certainty in a world of uncertainty.
• Capital outflows from the U.S.:   It flees to friendlier shores.  Badly needed domestic investment shrivels and the U.S. economy languishes.
• Never enough QE:  The $1.6 trillion QE1 did not revive the U.S. economy, so how will QE2's $600 billion?  Additional QEs will probably be implemented.  The Fed is independent and can buy whatever it wants, mortgage backed securities, bonds of all types, equities, you name it.  Eventually the U.S. will be forced to give up these futile attempts at stimulus; rates will go up and markets down as reality is faced.  The unfortunate fact is that QE has never worked in the long run.  Maybe this time will be different but don't bet on it.

Investment ramifications.

• Real assets:  Maybe stay with ETFs to avoid single issue risk. Precious metals (GLTR), agriculture (DBA), and energy companies (VDE) are but a few.  Click on the ETF tab on the Seeking Alpha website for additional ideas.
• Minimize fixed income investments (bonds): Upside risk is limited while the downside risk is infinite.  If you have safe treasury bonds and the incomes covers a fixed rate mortgage . . . maybe keep those -- some hedging is always a good strategy in times of uncertainity.
• Go with the trend:  As long as the Fed keeps its Zero Interest Rate Policy -- ZIRP-- you might consider some high dividend REITS such as Annaly Capital Management (NLY) and Chimera Investment (CIM) which benefit from ZIRP.  This is a risky area though as things can change quickly.
• Protection: You can protect yourself from rising interest rates with TBF and TBT but be aware of daily rebalancing erosion .

As always, do your own due diligence in picking investments.  Everyone's investment strategy and needs are different.  Only you can decide what is best for you.  This article only presents my thoughts on macro trends and is not a recomendation to buy or sell.   But, whatever you do, watch the bond market and Mr. Bernanke closely in the coming months and year.

Disclosure: Small positions in CIM and TBT

7 Speculative Chinese Small Caps

Looking for investments outside the U.S.?  You are not alone. With the dollar plummeting almost daily money seems to be fleeing U.S. shores faster than the Fed can print it.

Check out the Wild West . . .  err, I mean Wild East of stocks. East as in China, the elephant of emerging markets.  Now look at small-caps.  Scared yet?  After the Tuesday's action you should be!  Some Chinese small-caps fell 9-10%.  But wait . . . Yes, you can  find value and growth in Chinese small-caps.

Consider China Sky One Medical (CSKI) -- PE under 4, no debt, yoy revenue growth of 27%, and a Price/Sales ratio of 1.  Look at Duoyuan Printing (DYP) with its PE ratio of 1.4.  Then there is  Fuqi International (FUQI) which you can buy for only slightly more than its $6.27cash per share.  Both sell for less than 70% of annual sales and have P/E ratios less than 4.  Similar Chinese  small-cap values exist in CELM, CSR, LLEN, and UTA.

With those numbers how can you not like these stocks? . . .  I know!  I know!  Mr Market can be quite ingenious at finding ways of torpedoing the most obvious "buys".  But, like I said, this is the Wild East and anything can happen.  What goes down fast can go up just as fast.

Risks?  Where do we start?  Jim Chanos says China is the next Enron.  Sudden currency changes, an unpredictable government (I hesitate to use the word communist), and accounting irregularities are but a few of the potential negatives.   Volatility is frightening -- the smallest rumors can rocket up or torpedo prices.

Wealth management firms such as Northern Trust (NTRS), burned by the 2008 crash, play it conservative. They will never recommend these Chinese small-caps for their clients -- it would violate their fiduciary responsibility.  Individuals can, however -- if played right --, tap into some of the fastest growth markets in the world with these stocks at what by most standards are currently bargain prices.

Do you own due diligence -- small cap stocks are volatile everywhere, especially so in China.  My approach is to take small positions in several companies, sell those that fall 10% or so, but let the winners run.  Who knows?  You may tap into a Chinese superstar.

Think positive to avoid the Chinese market's Dr. Loveless like twists and turns.  James West and Artemus Gordon protected and won the day for the U.S. Maybe you can't protect the U.S. but you may be able to protect and enhance your portfolio with these stocks.

Trashed Real Estate, Soaring Gold

The prop wash from Ben Bernanke's helicopters has yet to spread dollars on the struggling U.S. real estate market.  Gold, though, up over 30% in the last year, is a major beneficiary,

Three years ago a typical Florida house (Tampa area) sold for $240,000 and gold was around $450/oz.  Now the house value has been cut in half to $120,000 while Gold has tripled and is closing in on $1,350/oz.   It took 535 ounces of gold to buy the house in 2006, today it only takes 90 ounces.  Why such a large about face?

Since both houses and gold are "real", non-printable assets one might conclude either houses are extremely undervalued and/or gold is extremely overvalued.  Is it just a matter of time before the pendulum swings back and the gold/house ratio rises again?

Gold is very much a global commodity, of course, while houses are the quintessential local asset.  You can easily move a pound of gold or more around around the world.  The real estate goes nowhere.

U.S. real estate has very low liquidity right now.  Loans are difficult to get.  Anyone can buy gold in vaious amounts easily, either through ETFs such as GLD or SLV.  Physical gold is available in the form of bullion or coins at the local coin store or numerous web sites (Be careful)!  In 2006 all you needed was a pulse to get a real estate loan while precious metal ETFs were just coming on the scene.

Years ago I went to a real estate seminar.  One of the things we learned was how to value houses using the income approach.  The "rule of thumb": A good middle class 3 bedroom/2 bath/2 car garage house in a good (not great) neighborhood is a buy if it sells for less than 100 times the monthly rent.  For example, if the house rents for $800/month a price of $80,000 (or better) makes it a good buy.

So, with that in mind, how do things look today?  The above central Florida house, renting for $800/month, can again be had -- with some negotiation -- for about $80,000 or less.   In 2006 the house was valued at about $160,000 -- way above the "rule of thumb" above -- an obvious red flag to those who paid attention.

I believe real estate is now in the process of bottoming and will eventually follow gold higher.  Inflation, as evidenced by increasing commodity prices, now seems to be edging out deflation.  Real Estate appreciation will follow.  However, it will be slow due to liquidity issues and the poor U.S. economic recovery.

Disclosure: I own real estate, no positions in ETFs mentioned

America's National Parks and the U.S. Dollar

"No one is speaking English" whispered my companion. as we hiked through the Bryce National Park last week. We encountered a surprising stream of hikers on the back country trails.

Young (take it with some perspective, I'm 61), fit, and friendly, the trekkers seemed everywhere. Germans, Dutch, Asians, Australians, and people from I have no idea where, all cheerfully waving as they strode by. Americans that actually live in the USA?  Well, I'm sure some were around, but if so, they made themselves scarce -- perhaps whiling away the time in nearby Las Vegas.

The torch of leadership in the world is changing.  The U.S. still has its natural wonders  and a flood of visitors  is eager to see the unrivaled beauty of the American West.  The allure of the wild west draws back which fled over seas.

Consider:  It is hard to believe you could mail a letter in the U.S. with a 1 cent stamp at one time. Now it takes 44 cents (with rumors of more to come).  At least National Parks haven't devalued like stamps and other paper assets such as the U.S. dollar.
The U.S. still has its natural wonders.  A flood of overseas visitors  is eager to see the unrivaled beauty of the American West.  The Wild West entralled Europeans 150 years ago.  Now, the rest of the world has joined them.
However, the torch of leadership in the world is changing.  The U.S. dollar has lost 10% of its value just since last June. Our leaders seem hell bent on devaluing it even more as they try to perpetrate the illusion that we can have $30/hour manufacturing jobs and compete with people who work for $3.00/hour or less.

We are a deeply indebted nation and Asians (remember the "starving Chinese" your mother told you about) are calling the shots.  Fortunately, we grow,  most of our own food, so no need starvie.  Yet selling food overseas may soon become more profitable.

You got this crazy scheme:  The U.S. government prints money and then lends it to banks at zero percent interest (ostensibly to "stimulate" the economy).  The banks take the cheap money, buy longer dated treasuries (who else would buy them?) for risk free profits on the spread as they try to repair their balance sheets.  With the possible exception of "Cash for Clunkers" very little ends up in the hands of the American public.  The longer this charade goes on, the more impoverished America becomes.

We simply cannot afford social security, national healthcare, high minimum wages, highly paid government employees anymore but our leaders don't seem to get it.  The dollar is strong only when European crisis erupts -- they have similiar, possibly worse problems.

Even more disturbing a weakening dollar robs Americans of their savings by stealth. The bank statement may look good but the dollars buy less and less.  Forget about traveling overseas.  Cash and treasuries are a loosing game to everyone but the banks.  Most of us just aren't aware of it yet.
As the U.S. continues to sink into a recessionary quagmire you might consider investing in international blue chips, commodities, and emerging market ETFs, assets which have more than paper backing them.

Nervous about picking foreign stocks?  Use ETFs!  Since ETFs invest in multiple companies, most practically eliminate corporate risk by investing in dozens if not hundreds of companies.  You may wish to consider EEM (ishares MSCI Emerging Markets Index), GMF (SPDR S&P Emerging Asia Pacific), BKF (ishares MSCI BRIC Index), or DGS (WisdomTree Emerging Mkts SmallCap Div).

Its a little riskier but TBF and TBT provide protection and profit opportunities against the inevitable rise in U.S. interest rates as reality sets in.  And the flood of overseas tourists visiting the U.S?  Thank them!  They are returning some of the vast amount of dollars that have fled to foreign shores in recent years.


Disclosure: Long BKF, DGS, TBT

An ETF Portfolio for Both Yield and Safety

How can you find yield and safety in today's Zero Interest Rate Environment?  That is the question retirees and many others are asking?  Conventional wisdom says "You can't . . . the only safety is in cash or treasuries." Historically that has indeed been the case.

However, the U.S. government is currently doing everything possible to keep rates low, and of course we all know you can't fight the Fed.  First the Fed drove down short term rates to zero.   Now, they are targeting longer maturities.  This is a war on savers!

So, are cash and treasuries truly safe?  Considering the U.S. debt situation the short answer is: "no."  Remember deflation and even stagflation is the fixed income investor's friend --  your dollar buys more.  If inflation or currency devaluation occur you do not want to be caught long bonds!  Governments almost always print their way out of a debt crisis, igniting inflation.   The portfolio below, however, provides inflation protection in addition to yield.

The portfolio consists of 7 ETFs and has a yield (equally weighted) of 5.67% and shows a 29.7% YTD gain. Compare this to SPY's 2% yield and 1% YTD gain.  Also, remember, since we are talking ETFs you greatly eliminate corporate or individual sovereign risk.

•  .EMB Emerging Market Bonds (4.7% yield, 15.5%YTD return)
•   LQD  Investment grade Corporate Bonds(4.7% yield, 8.6% YTD return)
•   JNK  High Yield Bonds -- aka junk bonds (9.7% yield, 37.7% YTD return)
•   DGS Small Cap Dividend Emerging Markets (4.8% yield, 83.2% YTD return)
  
•   PEY  High Yield Dividend Achievers (4.3% yield, 3.6% YTD return)
•   IFGL  International Reit (9.5% yield, -3.5% YTD return)
•   VPU  U.S. Utilities (3.8% yield, 11.3% YTD return)

Depending on your particular situation you could over or under weight individual ETFs.  Think a big crash is coming?  Maybe stay away from JNK.  Think Emerging markets will prosper?  Overweight DGS.  Already own substantial real estate?  You could stay from IFGL.  Talk to your financial adviser before investing.

A few comments:  JNK is probably the riskiest.  Yet, hi-yield bonds have strongly out performed the supposedly safer SPY over the last year.  DGS, PEY, IFGL, and VPU  have real assets and provide inflation protection and growth potential in addition to yield.  All but IFGL show positive growth over the past year,  prospering in today's dis-inflationary environment. Strong emerging market exposure minimizes risk to heavily indebted developed countries.

Sure, you can hide out in cash and treasuries but you miss the income and capital appreciation potential of the above portfolio plus you run a significant risk of currency devaluation or inflation.  Hiding in a fox hole may only get you buried some day, maybe some day soon.

Again, investors should do their own research and consult with their own financial adviser before acting on any thoughts expressed here.