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The US Bond Bubble Continues to Mushroom

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert

December 4, 2012

The US Bond Bubble Continues to Mushroom
We’ve Seen This Movie Before – It Ends Badly!

IN THIS ISSUE:

1.  The Bond Bubble Continues to Grow

2.  Are Bonds Really “Safe” Investments?

3.  When, Not If, Interest Rates Start to Climb

4.  Revisiting the Equity Alternative Program

Overview

It was very tempting today to focus entirely on the “fiscal cliff” especially now that it is very clear that President Obama is more than willing to take us over it. Treasury Secretary Geithner made it clear to congressional leaders last week that the president will insist on his proposals for dealing with the fiscal cliff, which include $1.6 trillion in tax increases, very little in spending cuts (that may never happen) and the permanent end of the debt ceiling.

Yet talk about the fiscal cliff is everywhere in the media 24/7. So rather than repeat what you probably already know, let’s revisit a topic that should be near and dear to almost everyone who reads my E-Letters. That would be the bond market bubble. If we do go over the fiscal cliff, that could be bearish for bonds. Fortunately, I have an “alternative” that has the potential to make money if the bond bubble bursts.

Keep in mind that JPMorgan Chase estimates that a mere 1% rise in long-term interest rates will result in up to a 20% loss of value in long-dated bonds, including Treasury bonds. This is a topic that should be on every investor’s mind.

The Bond Bubble Continues to Grow

Over the past few months, I have written about the growing bond bubble and my concerns for investors who continue to herd into bonds and bond funds without considering the risk they are taking. This stampede into bonds has been going on for over a year, despite the fact that interest rates are at historic lows. Whenever interest rates start to rise, most bonds and bond funds will get hammered.

Last week’s mutual fund money flow report from the Investment Company Institute (ICI) tells it all. The report highlights recent money inflows and outflows from stock and bond mutual funds. I have highlighted the areas we want to focus on today. Money continues to flow out of stock mutual funds and into taxable bond funds, including Treasury bond funds, as you can see below.

Estimated Flows to Long-Term Mutual Funds

First, we see that the mass exodus from stock mutual funds continues and, in fact, accelerated over the past two reporting weeks. In the Domestic Equity line, we see that stock fund outflows more than tripled in the last two reporting weeks, with $6.6 billion and $7.5 billion in redemptions, respectively. Investors continue to call it quits on the stock market.

So far in 2012, domestic equity mutual fund outflows have totaled more than $130 billion.  Of course, that’s just a small fraction of the estimated $5.8 trillion held in stock mutual funds, but it does give us an idea of what many investors are thinking.

But the much bigger story is the continued massive amount of money flowing into bond funds, and especially taxable bond funds (including Treasury bond funds).  This love affair with bonds and bond funds has been going on for much of the last two years, even as interest rates are at or near historical lows.

Since the beginning of 2012, investors have poured over $242 billion into taxable bond funds. As I wrote in my recent Bond Bubble Special Report, everyone and their dog is in bonds or bond funds. We’ve seen this movie before, and it does not end well!

Are Bonds Really “Safe” Investments?

I have to wonder how many investors moving from stocks to bonds are thinking that they are reducing their risk.  I’m sure they have heard that Treasury bonds are the “safest investment in the world.” However, what they’re not figuring in is the effect of higher interest rates on their holdings.

Sure, Treasury bonds and even some corporate issues are great investments if you hold them to maturity, but many bond investors are not planning to do this.  Plus, those who invest in bond mutual funds do not have a maturity date to look forward to, as bonds are continuously bought and sold in these funds.

As everyone reading this should know, when interest rates rise, bond values go DOWN.  It’s one of the few absolutes in the investing world – when bond yields go up, prices go down, sometimes a lot.  This means that the value of bonds in your portfolio will drop when (not if) interest rates begin to rise in the future.

If you don’t believe me about the dangers of investing in bonds at a time when interest rates have nowhere to go but up, check out the following article by Jonathan Trugman in the New York Post last week.

QUOTE:

Bond bubble bust

By JONATHON TRUGMAN
Posted: November 24, 2012

There goes the nest egg.

There’s a record $16.3 trillion of US debt and a good portion of that is sitting in baby boomers’ portfolios like a ticking time bomb ready to explode, and most investors know little about it. “It’s my worst nightmare,” says a long-only bond fund manager. “There’s nothing I can do — the checks come in [from investors] every day, and I have to invest it.”

With Ben Bernanke’s debt paper floating through the market and the Fed chief vowing to keep rates low until 2015, some bond managers are hoping to get out before the bubble bursts and Armageddon hits.

And rates would not have to go through the roof to take out billions in principal for investors, most of whom are in bonds because they are nearing retirement. “If the 10-year [bond yield] goes up 100 basis points, that could mean more than $35 billion is lost,” says one bond trader.

One hundred basis points is just a 1% increase, which would put the 10-year [Treasury note yield] at about 2.6% [from 1.6% today].  The average 10-year rate of return over the last decade is roughly 4%, which, if we return to that yield, could put principal losses close to $500 billion, says a bond manager.

Bond prices (your principal) and interest rates (yield) move in opposite directions. When rates rise, bond prices fall. The inverse is, of course, true as well. When rates fall, the price (your principal) of the bond rises.

The problem today is that short-term Federal Reserve funds rates are pegged at zero percent. In addition, the Fed’s irresponsible bond-buying spree, dubbed QE, has driven even long-term rates insanely low, to 1.5 or 1.6 percent on the 10-year Treasury.

Without rewriting arithmetic, rates have nowhere to go but up — and, eventually, up quite a bit. And the principal invested in bonds will fall substantially.

Most older Americans have done their part, putting away a little bit each month towards their retirement, cutting back on household budgets and selling their riskier equity investments in favor of “safer” US Treasury bonds.

Well, that’s where they may have gone wrong. While most financial advisers still steer their near-retirement clients into bond funds, these are extraordinary times where the latest bubble — bonds — is about to explode, just like the two previous bubbles.

The Fed’s bizarre move “forward” into a massive multitrillion-dollar bond-buying binge has left all investors more vulnerable today than they were in 2000 after the Internet bubble, or the housing-bubble bust in 2008.

Investors implicitly understood that there were certain levels of risk inherent in Internet/technology stocks in the beginning of the dot-com economy, where an idea and a sock puppet could garner a $100 million market cap. The same applied a few years later, when investors saw the price of their homes double over three years on nothing more than easy credit and lax regulator supervision.

But sadly, few Americans understand just how risky bonds are at this very moment. For generations, investors have looked to US bonds/Treasuries as “low-risk” savings instruments, almost like a bank CD. Bond losses were always something that happened in other countries like Argentina, Greece or Portugal, not America.

It is not as complicated as some would pretend, but it is extremely important for all to understand — especially those planning on retiring soon. Pension plans, 401(k)s, annuities, IRAs — retirement vehicles have never been more at risk than they are now. [Emphasis added.]

Most Americans don’t spend their time trying to comprehend the likes of quantitative easing or yield curves. That’s what the bureaucrats get paid for.

However, everyone recognizes that they earn next to nothing on their money today, either in the bank or in other interest-rate-based products like bonds and money-market funds.

They also know that “something” is clearly not right. That intuitive “something,” that recognition, is all-telling. The Fed has forced the bond market into unchartered and very unsafe waters.

With Social Security, Medicare and Medicaid all on the chopping block because Washington overspent and mismanaged itself, retirement savings are even more important.

So after manipulating the bond market to bubbly levels that even Dom Perignon would be proud of, we have virtually no economic benefit to show for it.

END QUOTE

When, Not If, Interest Rates Start to Climb

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.

We all know that medium and long-term interest rates will go up at some point.  That means that the profit opportunities in most bonds, including Treasuries, will mainly be on the short side. In the short-term, of course, bond prices could move incrementally higher as the Fed continues its QE intervention.

What’s called for in this environment 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. 

In July, I introduced you to a money manager with just such a long/short strategy, the “Equity Alternative Program” offered by System Research, LLC of White Plains, NY.

If you haven’t yet looked into Equity Alternative, I highly recommend that you do so, especially if you are among the millions of investors who are trusting their money to Treasuries and/or other taxable bonds.

Revisiting 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 October of 2012, Equity Alternative has produced annualized returns of 18.9%, while holding its worst-ever losing period to only -12.91%.  That’s pretty impressive considering the S&P 500 Index could manage only a 2.08 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.

http://halbertwealth.com/equityalternative

Click here to view the short video.

Performance

Over the five-plus years of actual trading, the Equity Alternative Program’s results have been very impressive.  Trading both long and short, the Equity Alternative Program has posted gains that compare favorably 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:

Equity Alternative, Summary

Equity Alternative, Growth of $1000 Investment

Equity Alternative, Total Returns

Equity Alternative, Risk vs. Return Scatterplot

Methodology & Administration

The Equity Alternative Program employs a 100% mechanical, quantitative system to invest long or short in 30-year Treasury bond mutual funds.  On the long side, the program invests in the Rydex Government Long Bond 1.2X Strategy, which is modestly leveraged.  On the short side, the program invests in the unleveraged Rydex Inverse Government Long Bond Strategy. 

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 will move to cash (money market), but 100% cash positions are rare. 

Accounts are held at Trust Company of America.  Additional details of how the program is structured including fees, trading frequency, etc. are covered in our Advisor Profile available at the following link:

http://halbertwealth.com/forms/Equity%20Alt.pdf

Conclusion – Don’t Procrastinate!

For the last several months I have been urging my readers to consider how much risk they have in their long-only bond holdings. The most common reaction I have gotten goes like this: Gary, you are absolutely correct that interest rates will rise at some point, but you’re too early. That may be true, but markets often turn sooner than the crowd expects.

This is precisely why I believe that the Equity Alternative Program is such a good consideration right now, given its history of making money on both the long side and the short side. Since its inception in 2007 through October 2012, Equity Alternative delivered an annualized net return of 18.9% with a worst losing period of only 12.9%.

Best of all, EA’s best year was in 2008 when just about everything else got hammered. (As always, past results are no guarantee of future results.)

We all know that procrastination can be one of our worst enemies. While millions of investors know that interest rates will go up at some point, they continue to sit in long-only taxable bond positions. Even worse, as you saw in the first chart above, investors continue to herd into long-only bond mutual funds. In my view, this is a disaster waiting to happen!

Our surveys earlier this year found that over 50% of my clients and E-Letter readers are invested long-only in bonds and bond mutual funds. I don’t want to see my clients get hurt when interest rates turn higher, as they certainly will at some point.

At the very least, you might consider Equity Alternative as a “hedge” against the long-term bonds in your portfolio. The minimum investment is only $25,000.

Keep in mind that JPMorgan Chase estimates that a mere 1% rise in long-term interest rates will result in up to a 20% loss of value in long-dated bonds, including Treasury bonds. This is a topic that should be on every investor’s mind.

I encourage you to watch the short video on System Research’s Equity Alternative Program. Also, you may want to watch our recent webinar for more information and hear founder Vinay Munikoti explain the strategy in his own words. Or you can read our Advisor Profile if you prefer.

The Equity Alternative Program is available to individuals, trusts, IRAs, and employer retirement plans.  But you can’t enjoy the success of this program 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: 

 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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