Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
It is remarkable how the normally boring bond and credit markets have suddenly come to dominate the financial news. Due to the Chinese central bank crackdown on lending practices and mortgage rates skyrocketing from historical lows, the economy’s borrowing mechanisms are generating much attention and concern. Both stock and bond markets experienced turmoil in June as a result, and even the most respected bond investors experienced something new: record outflows of money from their funds. Many are realizing that bonds are not the safe refuge in troubled times that they believed.
A little market (and personal) history will put recent developments in perspective. Our time in the investment business tracks an extraordinary period for fixed-income investors; in 1982, even short-term “risk-free” government securities sported yields in the mid-teens; rates on home mortgages topped 20% at one point. Companies in the booming oil sector, which at the time were forecasting a future of rising commodity prices, borrowed at 15% to buy drilling equipment that ultimately rusted somewhere in Texas when oil prices collapsed a few years later. Some well-off individuals were expecting to live off the income from treasury bills.
Fast-forward 30 years to a time when short-term rates on government bills are compressed to almost nothing, long-term debt of the weakest of issuers has been issued at 5% or less, mortgage rates have been as low as 3.5%, and bonds issued by certain “frontier” market countries which hitherto would have found no takers have experienced heavy demand. As with the oil prices of three decades ago, steadily rising bond prices begat forecasts for more of the same. The primary beneficiaries of this state of affairs have been the debtors, who have been enjoying record low funding costs, and their bankers. As for individuals planning to live off of fixed-income investments of any kind: tough luck!
All trends contain the seeds of their own reversal, and this brief account alone should be enough to make investors think twice about putting money into fixed-income, as we have cautioned against for years. The current unusual environment in the fixed-income markets will eventually return to normal, and the capital losses that will then accrue to purchasers of new bonds will likely overwhelm any yield advantage those securities may currently possess versus cash instruments. In June, market participants got some idea of what this adjustment might look like when it comes to pass: bonds swooned and rates rose sharply at the mere hint that monetary authorities might begin to back off their easy-money policies later this year. Price declines in some cases wiped out a few years of income; longer-term treasury yields climbed abruptly to about 2.6% in the case of the 10-year note, up from 1.6% at the beginning of May. The “new lows” list of securities trading at their lowest prices during the last 52 weeks ballooned in size and was largely populated by income funds invested in all manner of bonds and other income-producing instruments throughout the world. Fixed-income investors finally experienced the downside of the desperate reach for yield that had unwisely come to play a significant role in their decision-making.
It didn’t take much to puncture the bubble of complacency that had formed in the bond markets since the financial crisis. A few choice words on the part of the Federal Reserve chairman served to put the investment community on notice that central banks’ extraordinary support for bond prices was not forever. (We suspect he was also intentionally trying to nip in the bud some speculative practices that had begun to creep back into the markets, practices which harkened back uncomfortably to the pre-crisis years). Fears about the continuation of Chinese economic growth (the Chinese almost single-handedly held the world economy together during the financial crisis) hit both bonds and stocks. Commodities slipped as well since China has been a source of demand for a wide range of goods—from metals to foodstuffs—needed to build its infrastructure and feed an increasingly affluent population.
Fearing the markets had “misinterpreted” their remarks, central bank officials in the US and EU sought to reassure investors that an expected “tapering” of stimulus efforts was not imminent. Their talk succeeded in calming the situation towards quarter-end, as did efforts by the Chinese central bank to prop up its shaky system of credit. When all was said and done, returns for the quarter came in at 2.9% for stocks and generally negative for fixed-income (intermediate-term U.S. treasuries declined 3.6%, for example). Year-to-date returns for equities were still quite good at around 13.8%. Once again it paid to ignore the incessant volatility and wailing on Wall Street. As one prominent observer of the investment community put it not so many years ago, society would be better off if most members of the Wall Street crowd were driving taxicabs.
Look at any chart of stock prices or indexes, long- or short-term, and you will see lots of squiggles — those continual, generally minor up-and-down movements that reflect buying and selling pressure caused by any number of factors, including company developments, emotions, external events, or, as was widely believed in the past, manipulation. Since everyone wants to be a winner, history is full of market analysts and operators who wished to gain as prices rose, while avoiding the declines. “Buy for the rise, and sell for the fall” was a traditional formulation of this idea. More recently, “asset allocation” schemes represent attempts to do much the same thing: determine which sectors are likely to rise next (and preferably at the fastest rate), and which will fall or at least “underperform.” Such methodologies gain credence especially in the aftermath of big market downturns. At just those times investors are susceptible to the lure of systems that seem to offer a way to avoid the unpleasantness of having to watch your portfolio decline in value. In the series of market booms and busts that began in 2000, some of these strategies have, in fact, done relatively well, and, as such, have found favor in the investment product marketplace. Before moving on to specifics, some background is in order.
In the 1950s the chart squiggles caught the attention of statisticians, for whom the price fluctuations provided endless “data points” that fit nicely into statistical formulae, and “Modern Portfolio theory” was born. Central to MPT is the notion that price fluctuations — volatility,” — define risk in securities investment. Another important concept is “correlation,” which describes how security prices fluctuate with respect to each other or the general market. Combining securities with low correlations, or whose prices move independently of each other for the most part, could produce portfolios whose overall risk, or volatility, would be less than that of the individual components. The old investment maxim of diversification was given at least a semblance of mathematical rigor.
“Risk parity” funds are one of the products that have drawn favorable attention since the financial crisis. These funds have attracted upwards of $200 billion in assets spread among mutual funds and various alternative investment vehicles such as hedge funds. These products “promise to make money in most environments,” as The Wall Street Journal recently reported. Despite the lofty goal and an impressive theoretical pedigree, risk parity is essentially Wall Street’s latest version of the “buy for the rise and sell for the fall” routine, an attempt to avoid volatility, especially to the downside. The secret lies in employing assets of low correlation, including stocks, bonds, commodities, etc., but “levering up” on the less risky asset, perhaps using borrowed money or, importantly, derivative instruments for the purpose. For example, this might entail purchasing bonds — a low-volatility asset — and expanding exposure to that asset with borrowings or contracts whose value is tied to that of the bonds. Financial leverage has the effect of enhancing returns from the asset so purchased (as long as the returns on the asset exceed the cost of the leverage). So, buy more of the less risky asset, but get returns more akin to those of a more volatile asset such as stocks. Magic — the same return with less risk!
We have to chuckle when we hear of these schemes that promise to reap the benefits from investing in capital markets while avoiding their most notable characteristic — volatility. Wall Street has always drawn many who think they can ride the markets up and get out before the inevitable fall. Sometimes it seems to work; in the 1990s, a period of rising stock prices, the risk parity idea found few takers. The concept gained adherents afterwards as it offered relatively better results during a difficult ten-year period for the equities markets that began in 2000. To the great frustration of investors, stocks rose and fell and over the course of the “lost decade” and ended the period little changed, while bonds continued their already decades-long rise.
The ultimate result, however, promises to be the same as previous attempts to defy the nature of markets — disappointing. In the end the real risk lies in financial leverage. Correlation, as it turns out, is not low: during the second quarter of 2013 practically all assets declined together, wreaking havoc with the statistical models, and returns. Leverage works to the downside as well, and risk parity funds declined about 7% during the first half of the year, far worse than the averages, or even the standard asset allocation regimes they aim to improve upon. As with many Wall Street creations, the schemes tend to work for a while for the early adopters, then fizzle out as more money rushes in hoping to follow on the early success. On a more fundamental level, the culprit lies in the statistical formulation of risk, equating it with price volatility. Looking back at the charts and past the squiggles, the long-term trend of stock values has a persistent upward bias that reflects the economy’s gradual, long-term expansion. That is what should catch the attention of the genuine investor.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 27 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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© Copyright 2013 Dennis C. Butler, All Rights Reserved
Revised: July 11, 2013 TAF
© Copyright 2013 Dennis C. Butler, All Rights Reserved