Monday, January 28, 2013

Dangers of Fighting the Last Investment War?

Tadas Viskanta of Abnormal Returns writes on the dangers of fighting the last investment war:
It is often said that generals are always preparing to the fight the last war. The same thing could be said of investors as well. Investors are prone to extrapolate the recent past well into the future. For example, nearly four years into a bull market only now are investors beginning to put money back into equity mutual funds.

This point is well-illustrated in a series of graphics from David Rosenberg, via Business Insider, showing magazine covers from the most important eras finance of the past two decades. These include the Internet bubble, housing boom and the Great Recession. These compilations show how investors become slowly convinced as to the inevitability of the trend at hand.

In terms of trends there are few more well-established than the bond bull market. For over thirty years now bond yields have done little more than go down. Maybe because the trend has been so long-standing there is no cluster of magazine covers to highlight it. However a look at the graph below shows just how far yield have come from the end of the highly inflationary decade of the 1970s.

Some investors are taking notice that this downward trend in interest rates at some point has to end. Josh Brown at the Reformed Broker notes how the big bond mutual fund shops like Pimco and DoubleLine are ratcheting up their equity fund offerings to take advantage of what might very well be expected to be a change in interest rate regimes.

It has also brought out some skeptics of bond heavy, risk parity strategies.* What is a risk parity strategy? Michael Corkery at WSJ provides some background its growing acceptance.

A core tenet of risk parity is that when stocks are falling, bond prices typically rise. By using leverage, bond returns can help make up for losses on stocks. Without leverage, bond returns in a typical pension portfolio of 60% stocks and 40% bonds wouldn’t be large enough to compensate for low stock returns.

Leo Kolivakis at Pension Pulse notes risk parity strategies are more than just leveraging up bonds. However the heavy emphasis on bonds is what is giving some writers pause. Roger Nusbaum at Random Roger thinks the demise of risk parity is likely off a few years. However Stephen Gandel at Fortune is skeptical about the idea that leveraging up an asset at the end of a multi-decade bull market is necessarily a good thing. He writes:

But it’s also just the type of talk – that something like levering up your portfolio is safe as long as you use that leverage to buy bonds – that always pops up, and gets taken as gospel, just as bubbles are about to burst.

The bond bull market has gone on, with the help of the world’s central bankers, longer than most anyone would have believed in 1980, 1990 or even 2000. However at a time of calm bond markets and supportive equity markets, investors have the chance to think ahead to how a sustained rise in interest would affect them and their portfolios.

Things change. Bull markets end. Sometimes quietly, sometimes not so quietly, see the stock market implosions of 2000 and 2008. Investors need be sure they are not fighting the last war but are looking ahead to the next one. The bond bull market will end some day and strategies over reliant on an interest rate tail wind will suffer. The big bond market guys are looking ahead. So should you.

**For a more technical take on the theory underlying risk-parity strategies see: Asness, Pedersen and Frazzini, “Leverage Aversion and Risk Parity,” Financial Analysts Journal, January/February 2012.
I've already covered my thoughts on the so-called bond bubble in my first comment of 2013, Buh Bye Bonds?:
Over the next year,  I remain convinced the US recovery will gain further momentum and China's growth will surprise to the upside, which is why my focus is on coal, copper, and steel ('CCS'). The key thing to watch is inflation expectations. If growth surprises to the upside, there will be a backup in bond yields and surge in risk assets. Sectors tied to global growth will do better than others.

But is the bond party really over? With all due respect to Leo de Bever, Michael Sabia and Jeremy Grantham, nobody really knows where long bond yields will be in five or ten years. True, historic low yields make bonds seem like a poor and risky investment but the world is suffering from an employment crisis and it won't take much to spark a new depression. This scenario will be bullish for bonds, bearish for risk assets. 
 On Monday morning, US durable goods orders jumped 4.6% percent:
A gauge of planned U.S. business spending rose in December, a sign that business worries over tighter fiscal policy may not have held back investment plans as much as feared at the end of 2012.

The Commerce Department said on Monday that non-defense capital goods orders excluding aircraft, a closely watched proxy for investment plans, edged higher 0.2 per cent. The government also revised higher its estimate for November.
One month data on durable goods doesn't mean anything but when you add it to a series of data coming in above expectations, it only proves what I've been warning investors throughout 2012, namely, the US recovery will surprise to the upside (note: my first job was as a fixed income analyst at BCA Research).

The bond market is taking notice. The 10-year Treasury yield now stands at 1.99%, just shy of the 2% mark and well above the 52-week low of 1.39%. Global stock markets are also taking notice as they hover near highs. In fact, both the S&P 500 and the Dow are nearing all-time highs.

Even if the rally in stocks continues to frustrate bears, the truth is this bull market gets no respect. Many investors remain skeptical, dismissing the rally as another bubble. They will regret this stance, just like smart money did in 2012 when it fell off a cliff.

Does this mean the bond bubble is on the cusp of exploding? Not so fast. Some pretty savvy bond investors think the "bond bubble" argument is premature and are picking their sectors and geographies more carefully.

But billionaire financier George Soros recently told CNBC that there will be a dramatic rise in interest rates as soon as there are clear signs the US economy is picking up. Soros also warned of a currency wars, which I dismiss as pure fiction. In another interview, Soros told Bloomberg that hedge funds can't beat market because of fees. Very true, which is why wise hedge funds are chopping fees in half.

Below, George Soros talks about the European sovereign-debt crisis, inflation risk and his Open Society Foundation. He speaks with Francine Lacqua at the World Economic Forum's annual meeting in Davos, Switzerland.

Also embedded an interesting panel discussion moderated by Bloomberg's Francine Lacqua, featuring Bridgewater's Ray Dalio, on the role of central banks in the new normal. Listen to Dalio's comments carefully as he states "normalcy is not like the past," meaning countries will not be able to spend like the past and the "shift of the discussion" will center on productivity, not the debt cycle.