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.

June was a month of relative reprieve from the ongoing European fiscal drama. Favorable outcome in the Greek election combined with the agreement among Eurozone members to move toward an FDIC-like bank support model went a long way to soothing the nervousness that griped the capital markets at the beginning of June.

Of note during the month was SEC Chairwoman Mary Schapiro’s comments before Congress in which she advocated for the changes in the structure of money market funds, as recommended by the Volker rule. Specifically, she’s in favor of daily mark-to-market valuation of the Net Asset Value of the funds. As it currently stands, money market funds maintain straight line amortization/accrual of their bond holdings, thereby always maintaining a stable NAV of $1.00. The problem is that when the valuation of one or more of the fund holdings falls sharply, the fund is forced to abandon its steady NAV and mark the portfolio to market, an occurrence known as “breaking the buck.” “Breaking the buck” is usually a precursor to a run on the fund. A glaring example of such a run occurred in 2008 when The Reserve Fund was forced to suspend redemptions following the Lehman Brothers bankruptcy. In moving to a daily mark-to-market valuation, or floating rate NAV, the money market funds would experience daily performance variation and the “breaking the buck” issue would go away.

In addition to floating the NAV, Chairwoman Schapiro is a strong advocate of having the money market mutual funds hold back 3% of every fund liquidation for 30 days. The intention of the rule is to lessen the impact to the fund should a material percentage of fund investors decide to liquidate. From our perspective, the idea is badly flawed. Should a material percentage of investors decide to sell the fund at once, it’s likely a fundamental problem is at the root of the redemption and a 3% holdback would do little to resolve the problem. In the money market space a sudden drop in assets under management begets a run on the fund. A 30 day hold back would only exacerbate the run given that the first to redeem would be the first to get their remaining 3%.

During the testimony, Chairwoman Schapiro disclosed the rather surprising news that since 1970 there have been more than 300 occasions in which a mutual fund management company injected cash into their money market fund to avoid “breaking the buck.” Moreover, she characterized the $2.5 trillion dollar industry as having grown so large that the potential exists for a money market panic to destabilize the global financial system. From her comments, it’s clear to us that the money market mutual fund industry is not the riskless “mattress” that it has come to be viewed, but instead a threat that requires immediate attention. With regard to the two proposals, we’re in favor of the mark-to-market concept, but not the holdback. In moving toward marking-to-market, investors will come to understand that there is risk in their holdings and will be able to compare the riskiness of competing funds much as they do when comparing any other mutual fund. However, we think that the holdback idea is not a good one and simply attempts to protect poor portfolio management. Investors, both retail and institutional, consider their money market fund to be cash and are not going to be happy to learn that it’s only 97% cash.

While the effort has been in the works for some time, it now seems that the likelihood of implementation is growing. Despite the radical changes being discussed, it doesn’t appear that the investing public realizes that changes are afoot. It should be interesting to observe investor response. At the very least, we expect institutional investors to shift assets out of money market funds and into separately managed accounts.

Also of note during the month, the Bureau of Labor Statistics released the third and final version of first quarter GDP. While the report reconfirmed that economic growth for the period was 1.9%, it revised quarter-to-quarter aggregate corporate profit to a slight decline; the first decline in 12 quarters. Digging deeper, the report showed that the profit shortfall was driven, not surprisingly, by the problems in Europe. Domestically, corporate profits grew at a healthy 2.66% quarter-on-quarter, with all industry segments improving. However, profits generated from the rest of the world fell a worrying 11.7%, quarter-to-quarter. The question going forward is will that profit contraction prove transitory, and if not, how will it impact the equity market? Anecdotal evidence of economic weakness and the 5% appreciation of the dollar versus the Euro during the quarter don’t offer much hope for a bounce in European profitability in the second quarter. As we commence earnings season, we’ll be watching closely for clues.

As we conclude another robust earnings season, media attention has fixated on select weaker economic data, while ignoring economic strength. In the previous two years, global economic activity has slowed as spring arrived in the northern hemisphere. Anticipating a third consecutive year of second quarter weakness, investors over the last six weeks have reacted by selling stocks and buying Treasury notes. Again this year, the insidious phrase “sell in May and go away” is freely offered as a sensible investment strategy. Given that backdrop, the month was characterized by a flight to U.S. Treasury notes, with the Yield-to-maturity of the 10-year note falling 30 basis points, closing out the month at 1.91%.

Indeed, the list of potential stock rally-ending events is worrying. The ongoing fiscal and growth issues in Europe are first and foremost. From the continent, fears include of the willingness and ability of Spain and Italy to close their yawning budget deficits without sending the European south into a deep recession. Also of concern is the willingness of Francois Hollande, the newly elected President of France, to follow the path of economic unity established by former President Sarkozy and German Chancellor Merkel. Yet another worry, though to a much lesser extent, is the ongoing problems in Greece. With the country lacking leadership, the risk of an exit from the Euro is rising, although the damage would be minimal compared to the risk that existed last year. Offsetting those concerns, the risk that the European banking sector posed last year has been mitigated by the Long Term Repo Operation funding implemented by the European Central bank.

While investors grappled with fear that economic growth in Europe would spillover to the United States, the Federal Reserve expressed a less accommodative tone and suggested that the possibility of a third round of quantitative easing was less likely. At the conclusion of the April 25th Federal Open Market Committee meeting, Chairman Bernanke described monetary policy “as being approximately in the right place at this point.” Moreover, the committee was quoted as seeing “some signs of Improvement” in the housing sector with the expectation that housing activity would “pick up gradually.” In addition to less accommodative language, the forecasts presented by the Federal Reserve members reflected an upgraded expectation for economic growth. Their forecast for the unemployment rate at year-end 2012 is now 7.8% to 8.0%, a significant reduction from the 8.2% to 8.5% forecast that was presented in January. Even more surprising was the change in their Fed Funds forecast. The Chairman continues to guide investor perception to a 0.25% Fed Funds rate until late 2014. However of the 17 forecasts, only 4 members now expect Fed Funds to remain at 0.25% through 2014 and only 7 members forecast a rate below 1.0% at that time.

Also commanding attention has been a marginal slowdown in economic activity that began in March and continued through April. It now appears that the mild winter pulled activity forward at the expense of second quarter growth. The most glaring example is the slowing rate of job creation. After adding an average of 250,000 jobs in December, January, and February, job growth over the last two months has been 166,000 and 130,000 respectively. We believe that the slowdown in job creation will be temporary and are already seeing evidence of improvement in the weekly unemployment insurance claims rate. After spiking briefly in April, initial claims have again drifted lower, seemingly indicating that job growth is again gaining steam. Another measure of the job market is the Jobs Openings and Labor Turnover Survey, known as JOLTS. The JOLTS survey presents the total number of jobs currently available but not yet filled. In March that figure climbed to 3.737 million jobs, the highest level since July 2008. Digging deeper into the report every category, save government, saw an increase in help wanted.

As we commence this month, we think to sell in May, or to buy into the Treasury rally, would be a mistake. Economic activity continues to improve with the housing market showing signs of bottoming, gas prices have eased, and U.S. manufacturing continues to enjoy a renaissance. Moreover, as the Federal Reserve’s manipulation of Treasury note prices concludes at the end of June, a very large marginal buyer will exit the market. We wouldn’t be surprised to see investors sell Treasury securities in advance of the end of that program. Certainly, investors will continue to be subject to heightened volatility caused by “tape bombs,” as market moving bad news is known on Wall Street. However, we don’t expect that to derail the accelerating recovery in the United States.

Despite the price weakness observed during the month, we continue to believe that U.S. Treasury interest rates remain artificially low and that corporate and municipal debt offers an attractive investment opportunity. To detail that thesis, we’ve prepared the following valuation discussion.

In its simplest form, valuation is the expected purchasing power (also known as the real rate of return) of a dollar invested in a bond at the end of a holding period, given the current interest rate and anticipated rate of inflation. The starting point for this exercise is the U.S. Treasury note, also known as the “risk-free” rate. Note that “risk-free” refers to credit-worthiness, not interest rate sensitivity. As Figure 1 illustrates, the risk-free Treasury rate can be described as a combination of the inflation rate and the real rate. In 2005, a 7-year Treasury note yielded 4.43%, but 3.40% of that yield was compensation for expected inflation, as measured by the Consumer Price Index. From that, the investor expected to be rewarded with 1.03% more buying power at the end of the one year holding period. The “rule of thumb” among bond investors is that a real rate of 1.0% is approximately fair value. At the end of 2005, one could conclude that the 7-year note in question was fairly valued. The circumstances today are much less favorable. With the 7-year note yielding 1.38% and inflation registering 3.0%, an investor holding the note for one year would realize 1.62% less buying power at the end the holding period. Using the 1% real return “rule of thumb,” the current 7-year note would need to rise to 4.0% to be considered fairly valued. Inputting that interest rate differential into a bond calculator delivers the astonishing conclusion that the price of the 7-year note is 15% overvalued.

Turning to the corporate bond market we employ a similar relative valuation technique to determine fair value. In this exercise we use the Barclays Capital U.S. Credit Index as a proxy for the corporate bond market. The index has interest rate sensitivity similar to the 7-year Treasury note. To assess value, we subtract the yield-to-maturity of the 7-year Treasury note just discussed from the yield-to-maturity of the index. The difference is defined as the credit risk premium, or the incremental return the investor expects for assuming credit risk over and above the risk-free Treasury note. In 2005, subtracting the 4.43% risk-free rate from the 5.30% yield-to-maturity of the index indicated that the credit risk premium was 0.87%. Again, using rule of thumb, fixed income investors would consider a risk premium of 0.87% to be a close approximation of fair value. Refocusing on the yield-to-maturity of the index at the end of February 2012, the credit risk premium stood at a significantly more attractive 1.68%. Returning to the bond calculator, we find that an investor would enjoy approximately a 5.5% appreciation in the price of the portfolio if that spread were to narrow from the current 1.68% to 0.87%.

Considering the two measures of valuation, an investor could conclude that assuming the risk of a 15% loss to achieve a 5.5% gain doesn’t make a lot of sense. After all is said and done, the outcome would result in an 8.5% loss. However, to offset the interest rate risk, we have positioned short interest rate hedges through the futures and options market. In doing so, we are attempting to profit from the relatively attractively priced corporate and municipal markets while neutralizing the downside risk inherent in U.S. Treasury notes.