Municipals and Treasuries

Last year, 2008, municipal bonds had a rough year relative to U.S. Treasury bonds. With the flight to quality during the credit crunch of 2008, 10-Year Treasury bonds gained 14% more than their muncipal counterparts, on average. This performance difference was best reflected in the comparison between AAA municipal yields and U.S. Treasury yields. In late 2008, AAA municipal yields were a staggering 130% of Treasury yields on many parts of the yield curve. As an example, a 10-year Treasury yielded 2.25% and a 10-year municipal yielded 3%, and the after tax benefit was even greater especially if the municipal bond was your own state’s issue.

However, as the credit crunch has eased and the flight to U.S. Treasuries has been halted, we’ve seen a much different picture so far this year. The chart below compares the year to date performance of the 7-10 Year Treasury ETF (IEF) with the intermediate National Municipal Bond ETF (MUB). Treasury investors have a lot on their mind with supply concerns, inflationary pressures that could build in a few years, and now, dare I say, potential downgrade concerns. And while municipal investors may have their own default concerns as states battle budgetary problems, investors have clearly felt more comfortable in that space recently since munis have handily outperformed Treasuries this year.

It is generally assumed that investors will own Treasury bonds in tax deferred accounts and muncipal bonds in taxable accounts, in order to maximize after-tax returns. But the last year and a half has really shined a light upon total return investing in bonds. The huge return differentials over multi-month periods argue for a more actively managed approach to managing bond portfolios, which is our strategy here at Pinnacle.

Inflation or Deflation?

There is an intense debate among investors about whether inflation or deflation is the greater evil lurking around the corner. There’s no question that deflation has been the stronger force since the credit crisis picked up steam starting last summer, causing the global financial system to nearly implode during the second half of last year. Economic activity largely shut down, causing steep declines in nearly all asset prices. For example, the Dow Jones/AIG Commodity Index collapsed by -57% from its high last July to its low in February. More recently, the Consumer Price Index was reported to have fallen by -0.7% in April from a year ago, the lowest reading since the 1950s (see chart below).

Lately, there’s been a lot of talk of “green shoots” – tentative signs of economic recovery. Stock markets have rallied, commodities prices have perked up, and bonds yields have risen, as economic data has begun to level off from a freefall. A growing number of investors are interpreting these developments as signs that the market has begun to adjust to an inevitable wave of inflation, thanks to the massive government efforts to rescue the financial system.

We believe that the threat of deflation still exists, although perhaps to a lesser extent than a couple of months ago. Despite the endless talk of green shoots, the slightest misstep by policymakers or some unforeseen shock at this juncture could cause a major setback to the fragile recovery and would likely tip the scales definitively back towards deflation. We fully recognize that inflation may in fact lie in wait, but due to the severity of the ongoing economic problems, we think that threat lies further down the road than the inflationists believe.

Don’t Mistake The Secular For The Cyclical

Today, in the midst of the worst recession during the post-WWII period, and after a particularly horrific bear market where the S&P 500 dropped 58%, there are many compelling arguments for why the financial markets are on the precipice of a breakdown to new lows. It’s hard to dispute that the long term prognosis for the U.S. economy appears challenging due to a number of headwinds that exist, such as large debt levels that are now deflating, a savings rate that is just starting to rise (implying less consumption spending going forward), a government fist that is tightening and seeks more regulation, and the strong probability of higher taxes and inflation down the road due to the desperate measures that fiscal and monetary authorities have implemented in order to “save the system.”

While all of the aforementioned problems are real and will change the way our economy works, I think the mistake that ultra bearish investors are making right now is that they are applying problems that will occur over years and decades (“secular”) to an asset allocation that needs to be positioned for months and years (“cyclical”). Yes, this period has brought about structural change to the global financial system, and yes, it’s hard to believe that the world will return to growth rates that were partially built on a Ponzi scheme and lots of leverage. But don’t overlook the fact that credit conditions are improving, housing affordability is way up, the frantic efforts of policymakers are aimed at jump starting the consumer, and the world economy is dynamic and finds ways to adjust. Lastly, don’t forget that all of the above should now be discounted and shouldn’t catch investors by surprise. Yes, the bears are retorting that the so-called “green shoots” we keep hearing about are about to turn into dandelions, and that this bear is not done roaring yet. But the bulls know that bull markets climb a "wall of worry," and the current wall is as high as it’s been in decades. They might warn the bears not to mistake the secular for the cyclical.

The bulls believe the market is climbing a wall of worry:

Chart source: Jim Stack, InvesTech Research

Does the Latest Market Rally Validate Buy and Hold Investing?

Lately I’ve been asked if the latest market rally, a record breaking move of 38% or so over the past few months, validates the idea that investors should just buy and hold stocks. For the record, there is no market move, either up or down, that validates the idea that valuations don’t matter and investors should blindly own stocks expecting to earn historic average returns regardless of the market’s value when they buy. However, I thought I would do some “back of the napkin” math to put this rally is some perspective.

If you bought the S&P 500 in March of 1998 and reinvested your dividends you would, as of Friday’s close, have almost exactly broken even on your investment. The actual price of the index on March 16, 1998 was 1,079. If you invested in the Vanguard Total Bond Market Index Fund on the same date you would have earned an annual return of 5.57%, very close to the expected returns for bonds if you made the sensible assumption that inflation was going to be 3% for the period. However, the historic premium for stocks over bonds is about 6%, so if you purchased stocks in March of 1998 with the expectation of buying and holding and earning the historic risk premium, you would expect to earn about 11% per year.

Here’s the bad news. If the S&P actually earned the 11% that was expected in order to validate the assumptions of buying and holding, the S&P would have to trade to a price of 3,400 tomorrow, a gain of 277%. If we look at today’s 10-year normalized (average) S&P earnings of $50, the market would have to trade to an unbelievable P/E ratio of 68 at that price. Or, let’s say you are a raving optimist and think investors would reward the stock market with a multiple of 30 times earnings, a prospect that is doubtful at best. In such a case, S&P earnings would have to impossibly and immediately grow by 126% to $113. The recent 38% rally in the stock market does nothing to validate the idea of buy and hold investing, unless we are going to rally an additional 277%. Notably, the volatility of stocks was five times more than bonds for the period, raising the question of what premium return would have been considered acceptable for investors who ate 5 times more volatility to earn it.

By the way, the next time the market gets to a PE multiple of 30, I will be happy to sell my stocks to the investors who want to buy and hold.

Losing Our Natural Stimulus

Gasoline prices are on the rise so far this year, which is a concern since jobless claims have been above 600,000 for 3 ½ straight months. This is not a good development for the already hurting US consumer. Below is a chart of the AAA retail gasoline price for the past year. As you can see the price of gas remained resilient throughout the first half of 2008 but did eventually succumb to the global recession. On December 31st, the price bottomed at $1.61 per gallon at the national level after falling from a high of $4.11. This provided significant stimulus to the American people as we consume roughly 140 billion gallons of gasoline per year (using Energy Information Administration 2008 statistics). This positive effect has reversed recently as prices have steadily risen since the beginning of the year and now stand at roughly $2.29 per gallon. Using a constant demand level this price rise reflects an increase consumer cost of $93 billion, which is not what the economy needs right now as it’s attempting to stabilize.

This increase will put enormous pressure back on the consumer and prices will continue to rise until demand falls or supply rises. The refiners have efficiently shut down production to support this price increase but I would love to see more supply come back on line to support demand at a slightly lower price and return some natural stimulus to consumers.

Markowitz's Lost Message

Harry Markowitz is considered the father of modern finance by many, and his paper, Portfolio Selection, published in 1952, is the foundation of the Nobel Prize winning body of work known as Modern Portfolio Theory. It provides the mathematical foundation for strategic asset allocation, which is how professionals apply buy and hold investing to multiple asset class portfolios. To the surprise of many, here is what Markowitz has to say in the beginning of his famous paper:

“The process of selecting a portfolio may be divided into two stages. The first stage starts with observations and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performance and ends with the choice of a portfolio. This paper is concerned with the second stage.”

It is shocking how Markowitz’s work has been misapplied by the investment industry over the years. Instead of using observation and experience to make assumptions about the future performance of available securities, investors are taught to use average past performance of available securities and assume that performance is a certainty. In fact, it is the misplaced “belief” that past performance will repeat itself in the future that makes me believe that buy and hold investing is more like religion than an investment strategy. Investors who misapply Markowitz’s models in this manner must have faith that the past really is prologue to the future. Investors must choose. They can either rely on average past performance for their beliefs about future asset class performance, or they can reach their beliefs based on thorough study of absolute and relative value, market cycles, and technical analysis.

We choose the second method.

Another Failure for Standard Deviation

Carl Noble, one of our excellent Pinnacle analysts, just passed around a chart from Ned Davis Research showing the short-term standard deviation of the change in price between the Financial SPDR, (ticker XLF), an exchange-traded fund that owns a diversified basket of financial stocks, and the rest of the market as measured by the S&P 500 Index. The chart shows that for the past 44 days the relative out performance of the XLF versus the broad market has been a 13 standard deviation event. In other words, the odds of this relative price move, using the common measure of risk in the industry, is somewhere around (give or take) once per 6,117,160,000,000,000,000,000,000,000,000,000,000,000 times. That’s a little less than once per trillion trillions. To put it mildly, this price move, as measured by standard deviation, is statistically impossible. Yet here it is, just another failure for using standard deviation as a measure of risk in financial models.

There are two lessons to be learned from the chart. One is that standard deviation can severely understate the probability of events in the world of finance, and investors need to take care when using financial models that use standard deviation to measure risk. Internally, we use standard deviation when we build our risk models that predict portfolio volatility. Externally, we use standard deviation as the measure of risk in the portfolio policy statements signed by our clients, and in the scatter charts we use to demonstrate portfolio performance. In each case, the user must beware. The models communicate a level of certainty about portfolio risk and volatility that can be invalidated by the misbehavior of markets. The past year has reminded us that our caution in using this risk measure is justified.

The second lesson is that after a 13 standard deviation move to the upside, it certainly pays to think about selling. I don’t know if we will ultimately execute the transaction in our managed accounts, but it sure has our attention.