Don't Get Caught In a Sucker's Rally!

Great article by Lance Roberts at Street Talk Live blog:

On June 21st, in the midst of a bond market meltdown I wrote an article entitled "5 Reasons Why Now Is The Time To Buy Bonds."  In that article I stated:

"For all of these reasons I am bullish on the bond market through the end of this year. Furthermore, with market volatility rising, economic weakness creeping in and plenty of catalysts to send stocks lower - bonds will continue to hedge long only portfolios against meaningful market declines while providing an income stream.

Will the 'bond bull' market eventually come to an end? Yes, it will, eventually. However, the catalysts needed to create the type of economic growth required to drive interest rates substantially higher, as we saw previous to the 1980's, are simply not available currently. This will likely be the case for many years to come as the Fed, and the administration, come to the inevitable conclusion that we are now in a "liquidity trap" along with the bulk of developed countries. While there is certainly not a tremendous amount of downside left for interest rates to fall in the current environment - there is also not a tremendous amount of room for them to rise until they begin to negatively impact consumption, housing and investment. It is likely that we will remain trapped within the current trading range for quite a while longer as the economy continues to 'muddle' along."

At that particular time bonds were being bashed by the mainstream media, analysts and economists alike.  However, from a contrarian viewpoint, isn't this exactly what we want to see to denote a "buying" opportunity?  Isn't our number one job as investors to "buy low" and "sell high?"  If so, the plunge in bond prices in month of June was certainly one of those rare opportunities to scoop up quality corporate and municipal credits at bargain prices.  

Not surprisingly, over the past couple of days, there has risen an affirmation of my viewpoint on bonds from both the media and investment heavyweights alike.

June 27th:  CNBC:  Jeff Gundlach Now Sees Bargains In Credit Markets

"Bond king Jeff Gundlach says the selling wave that roiled credit markets in May and June has come to an end.

'The liquidation cycle appears to have run its course with emerging market bonds, U.S. junk bonds, munis and MBS—all of which substantially underperformed Treasurys during the rate rise—now recovering sharply,' he told CNBC's Scott Wapner.

Gundlach, the founder of DoubleLine and co-manager of the $39.4 billion DoubleLine Total Return Bond Fund, told Wapner in an email that 'the 200-basis-point-yield rise on certain sectors brought absolute yields up to levels high enough to create a compelling value proposition.'

'Not surprisingly, investors have been drawn to these values leading to interest rate stabilization,' he added."

 June 26th:  David Kotok - Cumberland Advisors

"At Cumberland, we have lengthened duration while moving to the buy side. We are buying where we can and altering accounts and mixes of accounts as we can. We are taking advantage of this very opportunistic time."

June 27th:  Bill Gross: Current Bond Sell-Off Overdone

"Don’t jump ship now. We may have reached an inflection point of low Treasury, mortgage and corporate yields in late April, but this is overdone. Will there be smooth sailing tomorrow? 'Red sky at night, sailors delight?' Hardly. Will you be able to replicate annualized returns in bonds and stocks for the past 20–30 years? Hardly. Expect 3–5% for both. But sailors, don’t panic."

Well, you get the idea. 

As I stated previously the sell-off in rates have pushed yields to very overbought conditions in the short term.  As with all things, nothing goes straight up, or down, and huge divergences from long term means have historically provided opportunistic buying and selling opportunities.  Take a look at the chart I posted previously:

The chart above shows a weekly chart of interest as compared to its long term moving average. Currently, at more than 3-standard deviations overbought, the level of interest rates is unsustainable and a correction is in order. In the chart I have noted (vertical blue lines) every time that the 10-year interest rate has touched 3-standard deviations above the long term mean. In every single case, over the last 10-years, that was the absolute peak of the move higher. It is unlikely to be "different this time."

The reality is that our job as investors is to look for things that have gotten "out of whack" and creates buying or selling opportunities.  However, if you listen to the mainstream analysis these extremes are never paid attention to and ultimately leads to investor sorrow.  Bonds play a critical role in lowering risk in portfolios designed for long term returns.  With return of capital and income components - bonds not only enhance long term returns but lower volatility which leads to fewer emotional mistakes.

The Opposite End Of Extreme

The same analysis can be applied to the stock market for risk analysis purposes.  A couple of days before the latest FOMC announcement that sent stocks plunging I wrote an article entitled "3 Reasons Why Stocks May Tumble Despite Fed" wherein I stated:

"There is one truth about the markets, despite Federal Reserve interventions, that remains true: 'Stocks do not go in a straight line.'

During unfaltering advances in the market investors begin to migrate towards the belief that the stock market will continue its current trajectory indefinitely into the future. This is particularly true near market tops when almost every pundit, analysts and investor is touting why now is the time to 'jump in'. Of course, history is replete with examples of the disaster that followed such advice.

As we discussed at length in our recent weekly missive 'An Initial Sell Signal Approaches' prices can only move so far away from their long term average before 'gravity' sucks prices back. The chart below shows the S&P Index on a weekly basis (which smooths out day to day volatility) with a set of Bollinger bands representing 3-standard deviations from the mean."

The point to be made here is that for longer term investors who are managing their "retirement savings" - the analysis of market extremes can help protect portfolios from unexpectedly sharp declines and the identification of low risk buying opportunities.  Furthermore, such analysis can help investors reduce the common syndromes of "buying high" and "selling low" which is the complete antithesis of what investors should be doing.  

It was interesting last week when Josh Brown wrote an article entitled:  "So, Who Bought The Dip" in which he discussed that while hedge funds were selling "Mom and Pop Investors" were buying.  Of course, this is exactly what you would expect to be happening.  The chart below shows mutual fund inflows for investors.

 

As you can see individuals have a strong tendency to "buy" market tops and "sell" market bottoms as the mainstream analysis drives them to make emotional investment mistakes rather than logical allocation changes.  During the month of May, as interest rates started their parabolic rise, individuals plowed $18.3 billion into bond funds but only $3.3 billion into equity funds.  Only three weeks of the June data currently compiled, which is subject to big revisions, which shows that as the interest rate surge hit its peak individuals yanked out an astounding $32.3 billion from bond funds and just $96 million from equity funds.  Both of these numbers will be revised higher over the next couple of months with equity inflows likely turning positive. 

The data clearly supports the overall premise.  Investors are panic selling what is likely an intermediate term bottom in bond prices and holding onto to equities in what is clearly one of the most overbought, valued and extended markets since 2000 or 2007.   While the mainstream market analysis continues to tout "buy and hold" strategies - statistical evidence clearly weighs in favor of a rather significant correction at some point in the not so distant future.  While timing of such an event is difficult at best, given the extreme amounts of artificial intervention by Central Banks globally, the impact to investors portfolios devastate retirement plans. 

The biggest problem currently is that there is virtually no expectation, or analysis that incorporates the impact, of an average economic recession ever occurring again.  Since business cycle recessions have occurred with regularity throughout history; it is somewhat naive to expect that the current market trajectory will continue when we are already 48 months into the current economic expansion. The chart below, as discussed in "No Recession Now But When" shows the history of U.S. recessions and their respective impact on the financial markets (note: the analysis uses monthly closing data points)

What is important for investors is an understanding that, despite claims to the contrary, a recession will occur in the future. It is simply a function of time. These recessionary drags inflict lasting damage to investment portfolios over time. The table above shows the start and finish dates, prior peak, and peak to trough price declines during previous recessionary periods. The average draw down for all recessionary periods was 30.76% with an average recovery period of 43 months. For someone close to, or in retirement, this can be devastating.

After two recessions so far in this century, which coincided with very sharp market declines, investor's portfolios have yet to recover on an inflation adjusted basis. Furthermore, and most importantly, with a large segment of the investing population heading into retirement in coming years, the demand for income, over capital appreciation, will weigh more heavily on future market growth. Many individuals are now realizing their own mortality and the critical importance of "time" as an investment variable.  We simply don't live forever.

While the economy is currently not in a recession - the negative trends in the economic and earnings data certainly require monitoring. With very low lead times between non-recession and recessionary states it is very easy to get swept up in the mean reversion process as forward expectations are realigned with current earnings and economic growth trends. With a market that is driven more than ever by momentum, low volume and high-frequency trading - this reversion processes will continue to swift, and brutal, leaving investors little time to react to market changes. This time is NOT "different" - a recession will reassert itself at some point. 

What is important is whether you, and your portfolio, are prepared to deal with it.  Bonds are currently exhibiting some of the best valuations that we have seen in the last couple of years with the technical indicators stretched to extremes.  Exactly the opposite is true with the stock market with valuations (based on trailing reported earnings - the only true measure of valuations) pushing levels normally associated with bull market peaks, prices at extreme extensions and earnings peaking.  This is the time when investors should be thinking about taking some profits by "selling stocks high" and adding some relative safety by "buying bonds low".  After all - it is what we are supposed to be doing as long term investors.