Yesterday, I set about trying to determine a plan of operation for next year. This has proven to be a struggle, as a shift in the bell curve of possibilities suggests a greater number of probable outcomes. In simpler days gone by, I merely hedged for things getting better, or things getting worse. I tried to ask these questions:
+ How to best manage the decline in real interest short term?
+ How to best manage the risks embedded in the tails of the bell curve?
+ How to determine timing for increased exposure to equities?
+ Picking the appropriate point for real estate investment?
Possible Indicators:
+ CRB index
+ FIG gauge
+ ECRI index
Struggling with lower short term rates, I've discovered that I think of the bond market with the same broad brush strokes that I'd used for the stock market back in '94. Reading sophisticated fixed income thinking leaves me with a new awareness of things like spreads, curve plays, credit risk vs reinvestment risk and so on. I imagine it will be some months, if not years, before I can comfortable speak of bonds, as I do now of stocks. Speaking of which, I've become fond of thinking of stocks in terms of Pokeymon cards. Some are more popular than others, and the price level for them tends to vary directly with the level of public interest. <g>
There's been much talk of Muni's paying more than Treasuries, with Muni's having a tax advantage. Even a suggestion by a wise individual, Bill Gross, that CEFs of muni's might be worth looking into. I did some looking, and awoke the following morning with the memory of a lessor known muni fund marking down it's portfolio a huge amount overnight. Seems the muni market suffers occasionally from lack of liquidity and volume that provides sound market based pricing. Another risk to muni's is the callable feature on some, which implies a reinvestment risk treasuries don't have.
GNMAs share that reinvestment risk, and were recommended by the 10/31 S&P Outlook as a safe haven. After viewing the CRB index, and the Future Inflation Gauge, I nibbled some Nov 1 using the Vanguard GNMA fund. I figure I can cope with reinvestment risk better than credit risk. And I'm wondering if I can use the CRB/FIG to time exit prior to interest rates moving up. Oddly, this thought leads me to thinking of parallels to stocks, where individuals think they can exit before the crowd. Not a comforting thought... Nevertheless, buying GNMAs appears to be a hedge against Scenario One, that things might get a bit worse before getting better.
Which brings me to High Quality Corporate bonds. There’s been some buzz lately about these. Mr. Gross appears to be easing into them, as a relative value play within the Bond universe. And Jubek makes an interesting argument in their favor. Of course, I keep thinking to myself that interest rates are low- now isn’t the time to be buying bonds. That broad brush stroke. What argues in favor of high quality corporates appears to be a rare high spread over treasuries combined with the possibility that credit risk may decline if things go from downright ugly to stable. While I don’t own any of these at this time, I’m think of nudging a small position into place to go along with my GNMAs, probably via another Vanguard mutual fund. This would hedge things getting a bit better, Scenario Two, offsetting the GNMA position some.
There was one argument I read on realmoney.com, which went something along the lines of ‘If you aren’t comfortable owning corporate bonds, you shouldn’t own stocks’. At first glance, I accepted this pearl. But later, I started thinking that in the event interest rates rise, bonds will lose value whereas stocks may hold their own. I suppose in current conditions, that might be a tenable position, but I don’t think it holds true for all phases of the markets.
Four Future Scenarios
One: Probability 50%
Interest rates remain low as the sluggish economy struggles to adapt. Renewed growth remains six months on the horizon.
Strategy: Safety and Current Income. Cash, GNMAs, very selective stock exposure, possibly plays in OSX and SOX.
Two: Probability 35%
A modest recovery begins Q202. Interest rates tick up in anticipation of future inflation, hurting intermediate and long term bond pricing. Stocks begin a new, sustainable bull. Meanwhile, some bond-market players are already venturing to go, if not boldly, then selectively, into corporates.
The U.S. economy "will have a mediocre recovery; the investment-grade asset class would be top of the list to do well in that environment," says CSFB's Goldman. Jubek- improved corporate pricing might result from decreased credit default risk. Suggests Vanguard offers two good funds: Vanguard Intermediate-Term Corporate Bond and Vanguard
Strategy: Increased exposure to equities combined with high quality corporates. Cyclicals and Base metals. Note the risk of improved productivity in Russia and China to Nickel and Copper pricing in secular terms. As rebound progresses, some exposure to high yield. Look for Real Estate 12-18 months out.
Three: Probability 5% End of world bet?
Significant disruption of economic infrastructure due to continued terrorist activities. Improvised gasoline truck bombs damage electric power and rail infrastructure. Shipping ports damaged by container bombs. Equities suffer intermittent no bid drops on the back of increasing uncertainty. Trend towards martial law/police state continues, though economic activity continues. Israel survives and even prospers despite ongoing instability.
Strategy: ?Caution. Maintain a healthy cash cushion, selectively pick up stocks in downdrafts.
Four: Probability 10% Too much traction!
Higher inflation results from Fed Stimulus and poor Fiscal choices. (Stagflation or growth?) People rush from financial assets to real assets. Bonds prices collapse as nominal yields increase. Housing sales collapse due to higher mortgage rates.
Strategy: Selectively pick up real estate. Move income allocation into TIPS, probably via Mutual fund. |
