Despite the ongoing effort of the Federal Reserve to manipulate bond prices higher, the market experienced a mild bear market in January.  For the month, the price of the benchmark 30-year Treasury note fell more than 4% as investors reallocated money out of bonds and into stocks.  The selling was disproportionately focused on maturities of 5-years and longer as the Fed continued to espouse its “low rates for a long time” mantra.

Despite the correction in Treasury notes, high yield bonds bucked the trend and rallied in tandem with the stock market, which saw the S&P 500 jump more than 5% for the month.  The underlying theme driving rates and equities was a heightened appetite for risky assets.  The rationale being, with excess cash on the sidelines and Treasury notes yielding next to nothing, investors “need” to take more risk to generate return.  That translated into demand for high yield bonds and dividend paying stocks.  Our worry, especially with high yield bonds, is that the additional yield is not nearly enough to compensate investors for the additional risk.  At month end, the Barclays High Yield Index offered a yield-to-maturity of 6.61%, 470 basis points more than the Aggregate index.  Both on an absolute and spread basis, that’s expensive!  Moreover, as money pours into High Yield ETF’s, liquidity risk is growing.  As we’ve discussed on several occasions, the structure of an ETF has the potential to destabilize markets should investors rush to sell.  One way to measure market liquidity is to divide the market capitalization by average daily volume, which yields the average number of days to turnover the index.  A higher turnover rate is indicative of a more liquid market.  The two largest high yield ETF’s manage a combined $27 billion in assets, representing 468 million shares, with daily volume for the two totaling 9 million shares, or 1.9% of total shares outstanding.  By comparison, 7.5% of the market capital of the S&P 500 changes hands on a daily basis.  Based on those statistics, the S&P turns over every 13.3 days, while the two largest high yield funds turnover every 52 days.  To further the point, the constituents in the S&P 500 are widely followed, actively traded companies.  The same can’t be said of a number of bonds in the high yield ETF.  The conclusion, as we see it, is that should an event “spook” investors, the rush for the exit is likely to worsen the selloff.

With a budget deal still elusive, the automatic budget cuts scheduled for March 1st pose a near-term risk to the market.  If a compromise is not reached, we expect bond prices to rise in anticipation of a slowing economy and prolonged Fed easing.  However, longer term, the performance of the bond market is not so clear.  If the sequester tips the economy back into recession, bond prices are likely to go higher as the Fed continues to print money.  On the other hand, if the economy has enough momentum to offset the impact of the sequester, the Fed would likely reduce or suspend bond purchases earlier than expected, causing rates to rise.  At the time of this writing, investors seem to be handicapping the latter as the most likely outcome.

Economic data for the month continued to portray the economy as growing at a moderate pace, with department stores registering much better than expected sales, while employment continued to expand at a disappointingly modest pace.  However, one bright spot in the employment situation is manufacturing employment.  In the current decade, manufacturing employment has grown at an average of 13,000 a month with 86% of months showing positive growth.  Over the course of the last three years, the economy has added 479,000 manufacturing jobs.  That’s far better than the previous decade in which outsourcing sent nearly six million manufacturing jobs overseas.  For that period, manufacturing employment contracted an average of 48,000 jobs per month, with only 15% of the monthly surveys showing job gains.  It’s clear that the U.S. is enjoying a manufacturing renaissance.

At first glance, economic and market activity in November was much as it has been throughout the year.  The economy continued to add jobs at a modest rate, and at a pace that isn’t meeting the growth target of the Federal Reserve.  Retail sales bounced back from the weaker level  witnessed in October, as the notorious “Black Friday” and “Cyber Monday” shopping days blended into a four day shopping spree.  Retailers garnered much attention with their decision to open stores on the evening of Thanksgiving, but the bigger story was that internet shopping captured an even greater proportion of holiday spending.  We’ll be watching closely to see if retail sales hold up into December, especially given the heightened nervousness of consumers as they face the prospect of the higher taxes in the New Year.  At the time of this writing, the president and Congress have been unable to resolve the dual mandates of rising tax rates and across the board budget cuts.  It’s been estimated that no resolution would result in a contraction in annual GDP of approximately 3%, with such an outcome likely tipping the United States back into recession.  Federal Reserve Chairman Bernanke has warned about such an outcome and is taking steps to offset the negative impact should Congress and the President fail to act.  In his speech to the Economic Club of New York, Bernanke hinted that the Fed will extend its bond buying program when the current “Operation Twist” concludes at the end of this year.  As with consumers, it’s difficult to conclude if investors are prepared the potential “cliff.”  The bond and stock markets don’t seem to be in agreement regarding the risks of a failure to compromise.  With interest rates again trading close to crisis lows, bond investors are assigning a high probability that the fiscal cliff will either directly or indirectly cause an economic slowdown.  However, equity investors seem to be much more sanguine as the stock market has shrugged off the temporary weakness witnessed in November and is now trading well above the 1400 level on the S&P 500.  A failure to avoid the fiscal cliff would likely result in a meaningful weakening in the stock market.

Moving from the macro to the micro, we continue to see inconsistencies in the credit valuation and the performance of specific issues.  The volatility leader continues to be the financial sector, as it has been since the crisis first evolved, and as we expect it to be for the foreseeable future.  Financial spreads were marginally wider during the month as investors attempted to handicap the impact of the fiscal cliff on banks and brokers.  At the opposite extreme, Emerging Market fixed income, ex-Europe, demonstrated remarkable stability in the face of uncertainty.  We’ve written on several occasions that we find the emerging markets debt recommendation to be an interesting concept, but one that lacks substance.  The investment thesis for the trade is that with a lower debt-to-GDP profile than Developed countries and positive leverage to global growth, the emerging markets will enjoy improving credit quality and an appreciating currency.  As we’ve discussed previously, the argument breaks down with the leverage to the developing world.  If the developed market isn’t growing, emerging markets stall.  Nonetheless, we continue to witness “head-scratching” disequilibrium in valuation.  An example of which is the Republic of Uruguay’s issuance of 33-year debt last month.  The Republic of Uruguay, rated Baa3/BBB-, issued bonds at a spread above 30-year Treasury Bonds of +140 basis points.  To put that into perspective, just two weeks prior, BBB3/BBB-rated  Macy’s department store issued 30-year debt at a spread of +160 basis points.[1]  While similarly rated, we consider Macy’s to be of a higher credit quality and, with an additional 20 basis points of yield, to be the cheaper issue.  To understand why Uruguay is trading at a premium is to understand the segmentation of the bond market.  An Emerging Market mutual fund manager will have a mandate to maintain a portfolio of Emerging Market Debt.  That Emerging Market debt is trading at a premium to domestic corporate debt is of no consequence to the fund manager.  His job is dependent on the performance of his Emerging Market portfolio versus other portfolios with a similar mandate.  As we’ve explained before, we look beyond the idea of specific fixed income “buckets” in an attempt to maximize valuation to the portfolio.  If the Republic of Uruguay issued debt that offered a spread of +240 basis points above Treasury Bonds and +80 basis points above Macy’s debt, it’s possible that we would consider an investment.  At +140 basis points, we have no interest at all.

During October, the bond market came under pressure as investors grappled with better than expected economic data and a revival of inflation concerns. However, on-going quantitative easing provided support to the market in the final days of the month.

Friday October 19th, marked the 25th anniversary of Black Monday, the day in 1987 that the Dow Jones Industrial Average dropped more than 22%. In the months and weeks leading up to Black Monday, the U.S. was grappling with Fed uncertainty, as then Federal Reserve Chairman Greenspan was tightening monetary policy in an effort to dampen stock market exuberance. Concurrent with, and despite the tightening monetary policy, the U.S. dollar was in the midst of a multiyear slide against European economies, namely Germany, France, and the U.K., while the stock market was climbing the proverbial “wall of worry.” Feeding upon that worry, Wall Street firms were actively selling the concept of portfolio insurance as a risk management tool. Portfolio Insurance was marketed as allowing the investor to fully participate in the market as it rallied, but cut their losses in the event of a market reversal. The idea was that the investor could instantaneously exit the market by simply informing their broker to execute a program trade in which a basket of stocks were sold. For a fee, the brokerage firm would customize the basket, so that trade was loaded and ready to execute in advance of any market weakness. When the investor gave the signal, the brokerage instructed their computer to direct the sales to the Super-Dot system on the New York Stock exchange or the Auto-Ex system on the American Stock Exchange. It was explained that unlike the arcane and time consuming system of voice execution, the Super-Dot and Auto-Ex systems allow for immediate execution at then-prevailing prices. With the advantage of speed afforded by portfolio insurance, a portfolio manager would be able to get out before everyone else, as it was explained.

However, in practice, the system was deeply flawed. With so many managers participating in portfolio insurance, there was a cascading effect when everyone hit the sell button at once. Compounding that flaw was the assumption that the electronic sales would be executed in an orderly fashion. In actuality, as each sell order hit the market, the bid for additional shares automatically repriced lower. As a result, market orders were filled at lower prices than investors expected. The problem was exacerbated by the inability of the computers to process a much heavier flow of orders than had ever been expected. While trading was supposed to cease at 4:00 p.m., as usual, orders entered on the Super-Dot and Auto-Ex before the close, continued to trickle through for hours after the close. In a post-mortem of the disaster, it was concluded that the system was unable to handle the flood of orders, especially given how pervasively the portfolio insurance tool had been sold. After all was said and done, rather than mitigate risk, portfolio insurance worsened it.

With markets relatively calm and viewers seeking a respite from the seemingly endless political mudslinging, the financial media devoted much airtime on the 25th anniversary of Black Monday to the cause of the crash. Much of the focus was on portfolio insurance and the rhetorical question, does rapid-fire black box trading pose a similar risk to the market today. Given the periodic frequency of “flash crashes,” the consensus answer was a resounding yes! However, the reporters missed an equally worrying risk that has demonstrated some of the same attributes of portfolio insurance; namely, the Exchange Traded Fund (ETF) market.

The similarities between ETF’s and portfolio insurance are striking. Since the stock market bottomed in March 2009, ETF’s have proliferated and now boast assets equivalent to the largest of the large mutual funds. Touted as a low cost alternative to single stock investing with the added benefit of quickly entering and exiting the market, the sales pitch sounds eerily similar to that of portfolio insurance. Amid the enthusiasm, we believe that investors have overlooked some glaring risks.

The first risk to consider is that securities constructed in a bull market quite often overstate the demand and liquidity for the product. To understand this one must first understand that Wall Street is in the business of selling, not buying, securities. As explained in the ETF disclosure language, when investor demand exceeds supply for the shares of a specific ETF, the ETF sponsor goes into the secondary market and buys the securities to create the additional shares. In doing so, the sponsor profits from the transaction fees associated with the secondary market transactions and the expanding asset base upon which they can charge a management fee. The greater the demand, the greater the profit! Considering the alternative, in which investors panic and want to sell their ETF exposure, the dynamic is much different. Trading desks don’t like to buy securities in a falling market, and with the “Volker Rule” limiting their ability to commit anything more than nominal exposure to proprietary trading, their ability to absorb those sales is limited. In that instance, the “float” of ETF shares would need to shrink and the sponsor would be required to sell the securities that comprise the ETF back to their trading desks. In such a situation, the price decline would be exacerbated by the lack of buyers as the profit motive shifts from greed to fear. A similar situation to what happened when portfolio insurance trades were executed on Black Monday.

In addition to the hidden peril of liquidity risk, ETF’s can be deceptively expensive, despite sponsor claims that they’re a low-fee alternative to mutual funds. Again, as explained in the ETF disclosure language, owning an ETF is to own an interest in a portfolio of securities. The net asset value of the portfolio is the aggregate value of the securities held in that portfolio. While the price of the ETF usually trades at a price close to the net asset value of the portfolio, it’s based on what investors are willing to pay for the ETF, not the net asset value of the underlying securities. Quite often, in a rising price environment the price paid for the ETF is higher than the value of the underlying securities, thereby causing the ETF to trade at a premium. However, when investors rush for the exit, as discussed in the previous paragraph, it’s possible that the ETF could fall to a discount to the value of the underlying portfolio of securities, thereby worsening the performance of the investment.

Given the uncertainty posed by liquidity risk and pricing variability, investors should be cognizant of the size and mechanics of the ETF relative to the broad market. The financial press has touted the enormous size of the ETF market as an advantage, alluding that with size comes liquidity, which under normal circumstances, is accurate. However, when the worm turns and sellers want to exit, the size could cause the price to fall even faster than anticipated.

As equity investors rudely learned on Black Monday, 25 years ago, the “good idea” Wall Street sold them went dramatically wrong. While there are many positive attributes to the ETF market, to ignore the risk is to put ones portfolio in peril.

The heightened volatility in the fixed income market that first developed in mid-July continued into August, as investor continued to grapple with mixed economic signals and nervousness out of the Federal Reserve. The 30-year Treasury bond began the month with a yield-to-maturity of 2.54%, which rose to 2.95% mid-month before falling back to 2.67% at month end. That equates to a more than six percent price loss and a subsequent recovery of nearly five percent. The broad market, as measured by the Barclays Aggregate Bond Index, experienced similar volatility, with the index losing as much as 1.08% mid-month before closing the period with a gain of 7 basis points.

The Federal Reserve, at the conclusion of the September Federal Open Market Committee (FOMC) meeting, announced that they will begin a third round of quantitative easing. Specifically, they plan to buy $40 billion of mortgage backed securities in the secondary market every month. That’s in addition to the $40 billion of long maturity Treasury notes they are already buying in their operation twist program. Unlike earlier rounds of QE, the Fed did not offer an end point for the money printing exercise. That point was amplified by the statement that “the committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable length of time after the economic recovery strengthens.” As if the implications of open ended quantitative easing weren’t clear enough, Bernanke, in the press conference that followed, stated that the bond buying would continue until the economy improved “substantially.” The capital markets reacted to the message with a sharp drop in bond prices and an equally sharp rally in equity prices. In the twenty four hours after the announcement, the S&P 500 was approximately 2% higher and the 30-year Treasury bond approximately 2% lower in price. Historically, the Fed begins to reduce accommodation as economic growth accelerates and inflationary forces increase. The quick and dirty interpretation of Bernanke’s statement is that the monetary accommodation will continue even as inflation exceeds the stated target. With that acceptance of higher inflation, the already negative real rate of return on 10-year notes will become even more negative, resulting in reduced purchasing power when those notes mature. Conversely, tolerance of rising inflation means that nominal profit forecasts should be raised, which effectively lowers forward price/earnings expectations, hence the rally in the stock market. However, equity investors should take care, in that price/earnings multiples typically fall in a rising inflation environment.

We caution that tolerance for a “little more” inflation runs the risk of a rising inflation expectations spiral. Such a spiral works as follows. Consumers react to prices rising faster than expected by demanding a wage increase that is at least in line with the greater than expected price rise. As prices continue to rise at a faster rate than consumers expect, they continue to demand a wage that will keep them in line with rising prices, but will also demand an increment above that rate for assuming the risk that inflation will again register more than their last wage adjustment. In saying that monetary policy will remain accommodative as inflation rises implies that the Fed can break such a feedback loop. With such an enormous amount of liquidity already in the system and an enormous amount on the way, we’re concerned that the Fed will not be able to normalize policy without damaging the economy.

However, inflation is unlikely to spiral out of control or anything close to such an outcome in the near future. Our expectation is that the recent selloff will bottom as the Fed rolls the printing presses and buys paper in the open market. Also, economic uncertainty caused by the looming fiscal cliff is likely to keep a lid on economic activity. If anything, campaign “mud-slinging” may suppress consumer confidence and with it, fourth quarter retail sales. Despite that fear, we continue to remain defensive and seek to minimize our sensitivity to interest rates.