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Bond Investing - Itís the Short Side, Stupid

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert

July 10, 2012

IN THIS ISSUE:

1.  The Cliché that Won an Election

2.  A Secret that Everyone Knows

3.  The Bill Gross Effect

4.  It’s the Short Side, Stupid

5.  Introducing the Equity Alternative Program

The “Stupid” Cliché that Helped Win Clinton an Election

As you are probably aware, I am an avowed political junkie – but this article isn’t about politics.  Instead, I want to borrow a phrase from the 1992 presidential election as an analogy to highlight what I believe bond investors should be concentrating on right now – the short side.

As everyone remembers, Bill Clinton unseated President Bush (41) in the 1992 election, even though the task appeared to be impossible at the time.  One of the reasons he was able to do so was the help of a tagline from advisor James Carville: “It’s the economy, stupid.”  This phrase helped candidate Clinton’s campaign focus on the main issue important to American voters rather than Bush’s past accomplishments. 

How does a campaign tagline relate to investing in bonds?  Well, the moral of the campaign story is not to let your opponent’s past accomplishments and small distractions prevent you from seeing the current issues that are most important to voters.  On the investment side, it translates to not allowing past performance and short-term noise in the markets to take your focus away from longer-term trends. 

For purposes of this article, I’ll narrow my focus to 30-year Treasury bonds (T-bonds), but the same relationships apply to other types of bonds as well.  The elephant in the room is not that interest rates are at historical lows and bond prices are at or near record highs.  As long as long-term rates are above zero, they could always go lower in the short term, as bond-king, Bill Gross, found out in 2010 (more on this below).

The critical issue for T-bond investors is that when (not if) long-term interest rates go higher in the future, bond prices will go down, perhaps significantly.  It’s one of the few absolutes in the investment business.  You need to know how to take advantage of what happens in the short-term as well as the longer-term, and that’s what we’re going to talk about today.  If you are interested in a long/short Treasury bond program that has produced annualized returns of over 19% since its inception in 2007, read on.  (Be sure to read the Important Notes at the end of this E-Letter before deciding to invest.)

A Secret That Everyone Knows

Over the past year or so, I have penned several articles dealing with the future of long-term interest rates and my concern about the stampede into bonds.  The conclusion is always the same: Interest rates will go up at some point and when (not if) they do, bond prices and portfolios holding 30-year Treasury bond positions are likely to get hammered. 

As I mentioned earlier, there are few absolutes in the investment world, but the inverse relationship between interest rates and bond prices is one of them.  When long-term interest rates trend higher, T-bond prices will go down.  You can hang your hat on it.

Yet even though everyone sees interest rates at historic lows and knows of the inverse relationship between bond rates and prices, retail investors continue to pour money into taxable bond funds, (including T-bond funds) based on data from the Investment Company Institute (ICI).  That just doesn’t compute in my book.

Do investors think they can read the tea leaves well enough to get out of bond funds when long-term rates begin rising?  Or, maybe investors see T-bonds as a safe haven from the trials and tribulations going on in the world.  Let’s check this last one out a bit using the 30-year Treasury bond as an example.

As a general rule, if long-term interest rates increase by 1%, the price of a 30-year Treasury bond will normally decrease by around 10%.  Does that sound like a safe haven to you?

The Bill Gross Effect

Another reason that investors may be piling into bond mutual funds is what I call the “Bill Gross Effect.”  A couple of years ago, “bond king” Bill Gross famously called for an “end of the bond bull market.”  In case you don’t know, Mr. Gross is co-founder of the PIMCO family of mutual funds and currently manages one of the largest bond mutual funds in the world.  He’s obviously a sharp guy and is widely quoted in the financial media.

Like most people in the financial services business, he’s going to be wrong from time to time, and his call for the end of the bond bull market was one of those occasions.  After shifting his funds out of Treasuries in 2011, interest rates actually went further down, pushing bond prices even higher. 

As I continue to observe data showing massive inflows into bond funds ($123 billion so far in 2012 alone, according to the ICI), I have to wonder if these investors are hoping to avoid Mr. Gross’ fate of pulling out of the bond market too soon.  If so, they are taking a huge risk.  Just look at the graph below:

Thirty-year U.S. Treasury Bond Yields

As you review the above graph showing past and forecast Treasury yields, also imagine a mirror image line representing bond prices.  The sharp, jagged line shows that Treasury bond yields and prices are extremely volatile and can fall off a cliff without any warning.  Is this the kind of safety that mutual fund investors are seeking in taxable bond funds?

You will note that the chart also forecasts T-bond yields into 2014.  I want you to notice the general direction of the projected yields over the next couple of years.  The trend is expected to be generally upward, but a couple of pullbacks are also forecast.  This again calls attention to the need to trade T-bonds both long and short as these opportunities present themselves.

It’s the Short Side, Stupid

At this point, we have established that bond prices are at or near historic highs and appear to have nowhere to go but down in the long term.  Furthermore, we know that when interest rates begin to rise, T-bond prices have to fall.  Thus, since investing is a long-term proposition (or should be), our primary focus needs to be on the short side.  So what conditions might drive interest rates higher? 

Economists tell us that as the economic recovery improves, interest rates will eventually rise.  That’s the “normal” reaction in a strengthening economy.  However, the economic recovery is looking pretty weak right now, and some analysts are saying we’re heading into another recession.  So is it too early to be thinking about rising interest rates?

The answer is “not necessarily.”  That’s because a weakening economy could also result in higher interest rates.  If the economic recovery stalls out, we’ll likely continue to pile on more and more government debt.  At some point, without a strong economy to back our borrowing, foreign buyers of Treasury securities may begin demanding a higher rate of return to compensate for added risk.  The scary part about this scenario is that the Fed can’t control what foreign investors demand for bond returns. 

Some readers may now be thinking that the above scenario will never happen because the Fed would step in and print money in sufficient quantities to buy Treasury bonds, keeping interest rates low.  That may be true, but “monetizing” federal debt can have a nasty consequence – inflation, which can also lead to higher interest rates. 

Will any of these things happen in the short-term?  Maybe not, but the way I see it is that the outlook for the long-term future is screaming that opportunities will mostly be on the short side of T-bonds, even though we may see prices move higher in the short-term as the Fed continues its intervention.

What worries me most on the investment side is that we are seeing retail investors continuing to flock into taxable bond funds for a variety of reasons.  So far, they have been rewarded with gains as interest rates have trended even lower over the past couple of years.  However, when the balloon pops, it’s likely to be ugly!

What’s called for is a money management strategy that can position itself on the short side when interest rates start to rise, but also has the potential to take advantage of any gains on the long side as they become available.  That’s exactly what I want to talk to you about today, in that we have found such a strategy in the “Equity Alternative Program” offered by System Research, LLC of White Plains, NY.

The Equity Alternative Program

System Research founder and portfolio manager, Vinay Munikoti, recognized early on that the 30-year Treasury bond market offered the best opportunities for his management style, but he needed to find a way to potentially capitalize on both the long and short sides.  I’d say that he found it.

From the inception of the Equity Alternative Program in 2007 through June of 2012, Equity Alternative has produced annualized returns of over 19% while holding drawdowns to only -12.91%.  That’s pretty impressive considering the S&P 500 Index could manage only a 1.38% annualized return over the same period of time.  Of course, past performance can’t guarantee future results.

To help communicate the advantages of the Equity Alternative Program, we have produced a short video at the link below.  This video not only recaps the reasons to include Equity Alternative in your portfolio, but also provides some insight into how this proprietary strategy works.

Click here to learn more about the Equity Alternative Program.

Performance

Over the five-plus years of actually trading, Vinay’s results have been very impressive.  Trading both long and short, the Equity Alternative Program has posted gains superior to those of most broad stock and bond benchmarks.  The charts and tables below tell the story in greater detail.  Note that all performance information is shown net of management fees and mutual fund expenses (click a graph to display it larger):

Equity Alternative Performance

 

Methodology & Administration

System Research employs a 100% mechanical quantitative system to manage Rydex 30-Year Treasury bond mutual funds.  Long exposures use the Government Long Bond 1.2X Strategy, which is modestly leveraged.  For short trades, the unleveraged Rydex Inverse Government Long Bond Strategy is used. 

Both long and short positions can be scaled-in based on the strength of the trading signal.  Scaling back on allocations is also a risk management tool in volatile markets.  When neither long nor short positions are appropriate, Equity Alternative can seek the shelter of cash, but 100% cash positions are extremely rare. 

Accounts are held at Trust Company of America with back-office trading and administration through Purcell Advisory Services.  Additional details of how the program is structured including fees, trading frequency, etc. are covered in our Advisor Profile available at the following link: 

Click to see more information in the Advisor Profile.

If you have been reading my E-Letter very long, you know that my firm also offers another investment providing a long/short exposure to the 30-year Treasury bond.  It’s called the Hg Capital Long/Short Government Bond Program (LSGB).  LSGB invests in the same Rydex mutual funds in its trading but does so using a very different quantitative methodology.

In an effort to pre-answer a question about why we offer both programs, the primary difference between Equity Alternative and LSGB, other than being offered by two different managers, is that the LSGB Program looks only one day ahead for investment direction, while Equity Alternative’s trading signals last an average of 12 days.  While both approaches can be profitable in the right market environment, a combination of LSGB and Equity Alternative can have some real advantages.  Call one of our Investment Consultants to learn more.

Conclusion – Don’t Procrastinate!

We all know that procrastination can be an enemy of investing.  Yet millions of investors are sitting in long-only taxable bond positions, in cash on the sidelines or even still holding onto index-based equity positions.  They are awaiting the resolution of some potential market disaster before making any decisions to reallocate their investments.  In my over 35 years in the markets, I have never seen a period of time when there wasn’t uncertainty of some kind.  If you wait until all is clear, you may never invest.

At Halbert Wealth Management, we seek out investment professionals who have the potential to add value to your investing no matter what the current market environment.  System Research is one such Advisor, offering a long and short exposure to the 30-year Treasury bond.  Its Equity Alternative Program may be a good replacement for long-only bond positions, as well as for cash positions earning far less than inflation. 

On Thursday, July 12 at 4:00 PM Eastern, we will be sponsoring a free WEBINAR featuring Vinay Munikoti and his Equity Alternative Program.  In this webinar, you will learn more about how System Research manages client money and why you should consider a long/short strategy in your portfolio.  Just click on the following link to register for the webinar.  Space is limited, so register today.

Click to register for the Equity Alternative Webinar.

If you are unable to attend the live webinar, a recorded version of the presentation will be available on the HWM website (www.HalbertWealth.com) within a few days after of the webinar.

The Equity Alternative Program is available to individuals, trusts, IRAs, and employer retirement plans.  However, Vinay can’t put your money to work if you don’t invest.  So don’t procrastinate – contact us today in any of the following ways to get your Equity Alternative Investor Kit: 

As always, it is important to understand that the investments mentioned today have the possibility of loss as well as gain.  Be sure to read all materials carefully before investing, including the Important Disclosures below my signature.

Wishing you profits,

 

Gary D. Halbert

 

IMPORTANT DISCLOSURES:  Halbert Wealth Management, Inc. (HWM), Systems Research, LLC (Systems), and Purcell Advisory Services, LLC (Purcell) are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed.  Any opinions stated are intended as general observations, not specific or personal investment advice.   There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors.  HWM receives compensation from the Advisors in exchange for introducing client accounts to the Advisors.  For more information on HWM, Systems or Purcell, please consult their respective Form ADV Part 2, available at no charge upon request.  Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor's 500 Stock Index (which includes dividends) and the Barclays Long U.S. Treasury Index were used.  Both represent unmanaged, passive buy-and-hold approaches, and are designed to represent their specific market.  The volatility and investment characteristics of these indexes may differ materially (more or less) from that of the Equity Alternative trading program since they are unmanaged Indexes which cannot be invested in directly.  The performance of the S & P 500 Stock Index (with dividends reinvested) and the Barclays Long U.S. Treasury Index is not meant to imply that investors should consider an investment in the Equity Alternative trading program, which is actively managed, as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the US Treasury securities with a remaining maturity of 10 plus years that comprise the Barclays Long U.S. Treasury Index.   

Historical performance data from inception through March 31, 2011 represents a track record from an actual account at another advisor managed using the same strategy as the strategy used by the Systems Research to supply the signals to Purcell.  It has been adjusted for Purcell’s annual fee of 2.5%.  Performance from March 31, 2011 reflects the return of a representative account traded by Purcell Advisory Services.   The representative account has the maximum fee (2.5%) withdrawn, has been in the strategy for no less than two consecutive months with no withdrawals, distributions or additions.  Should the representative account fail to meet the criteria, another account that complies with the requirements will be substituted.  The representative account is held at Rydex Funds.  Accounts held at TCA are required to maintain a cash balance of 2% and are charged a custodial fee of 10 bps.  This is not reflected in these returns so actual returns for accounts at TCA will vary. Returns reflect the reinvestment of dividends and other earnings, and are net of all transaction fees.  Neither set of these performance numbers have been verified by HWM, and therefore HWM is not responsible for their accuracy. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Equity Alternative Program. 

Purcell utilizes research signals purchased from Systems Research, an unaffiliated investment advisor.  The signals are generated by the use of a proprietary model developed by Systems Research.  Statistics for "Worst Drawdown" are calculated as of month-end. Drawdowns within a month may have been greater.  PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results.  The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions, custodial fees and transaction fees charged to an account as well as any minimum cash balance requirements or additional fees for variable annuity accounts. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Equity Alternative trading program.

In addition, you should be aware that (i) the Equity Alternative trading program is speculative and involves risk; (ii) the Equity Alternative trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Purcell will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Equity Alternative’s trading  program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Any investment in a mutual fund or money market fund carries the risk of loss.  Mutual funds and money market funds have their own expenses which are outlined in the fund's prospectus.  An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.   Management Fees are deducted quarterly, and are not accrued on a month-by-month basis. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Individual account results may vary based on each investor's unique situation.  No adjustment has been made for income tax liability.  Consult your tax advisor. “Annualized” returns take into account compounding of earnings over the course of an investment’s actual track record.  The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.

 


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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