Investing

Leave it alone!

Some things just ought to be left alone. My son and I have often disagreed on this point. "Leave it alone!" "Why are you touching that?" "Stop rolling the window up and down." "Would you please stop pushing that button?" "Don't bother your sister." "Turn the windshield wipers off." "DO NOT PLUG THAT SCREWDRIVER INTO THE POWER OUTLET!"

Many investors to share his tendencies.

Meb Faber wrote a great study on various asset models called Global Asset Allocation. The book is a detailed performance analysis of eight "reasonable" but very different allocation strategies over the most recent forty year period.

These portfolios had stock allocations as low as 25% and as high as 90% (Warren Buffet's famous 90/10 allocation). They included a bond allocation from 10% on the low end to 55% on the high end. Real assets (commodities, real estate, natural resource equities) ranged from 0% in, two of the eight portfolios, all the way up to 50%.

While the reading is admittedly a bit dry, the conclusion is remarkable. Over the forty year period, these eight very different strategies all produced annual returns within 2% of each other (8.5% to 10.4%)!

On the surface this might not seem all that amazing, after all it matches what we've all been told about investing for the long run, right? However, consider that for "shorter" periods of seven to ten years (that surely must have felt like an eternity to under-performing investors) it wasn't uncommon for a given allocation strategy to have been outperformed by up to 100% by other strategies. That brings a whole new meaning to patience, doesn't it?

But the penalty for lacking patience can be harsh. The often quoted and annually updated DALBAR study shows that actual composite mutual fund investors returns have averaged only 2-3% over a thirty year period in which stocks returned better than 11% per year and bonds returned more than 7%. The only possible explanation for this huge performance discrepancy is investors buying after period of price appreciation and selling after periods of losses.

The last few weeks have been an excellent example of the temptation to "touch things" as investors have bid up industrial stocks (e.g. the Dow Jones Industrial Average or DJIA) and sold off gold mining stocks (the Philadelphia Gold and Silver Index or XAU). As often happens when prices change, sentiment (mood) indicators are now depressed for the mining shares and ebullient for industrial stocks. Does this make sense? Thirty years from now, we can be fairly confident that industrial companies will still be doing industrial things, and miners will still be mining gold. Trees won't grow to the sky, and gold won't become worthless. On the contrary, over many years, economic expansions, and recessions, it is quite likely that both US industrial companies and gold will maintain substantial value. However if you had to take either a share of General Electric or a gold coin, and then play Rip Van Winkle for a century, I bet you'd take the coin!

Understanding all of that, why wouldn't a rationale long term investor be more inclined to buy a little bit more of what is on sale and a little bit less of what has been marked up? First of all, my son would tell you it's because sitting still is tough sometime. Secondly, our human brains have learned that doing more of what feels good is fun. But following those normal psychological instincts flat out doesn't work for investing. Prices go up and down as a normal part of markets and the best way to lock in poor long term investment performance is to change strategy when it doesn't "feel good". Fortunately, good habits can eventually be learned with enough reinforcement...my son no longer tries to plug things into power outlets!

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Investing Superheroes: John Bogle

John Bogle has been a financial industry pioneer and respected spokesman for over fifty years. As the founder of The Vanguard Group, which specializes in low-cost index funds, he’s had tremendous impact in driving down the costs and complexities of market participation for millions of investors. Many of the standard components of sound investment advice weren’t standard before John Bogle.

Bogle’s Key Strategic Concepts:

  • Bogle starts with the importance of long-term thinking to investment success. “The historical data support one conclusion with unusual force: To invest with success, you must be a long-term investor”. This advice is so commonly heard, that it is easy to overlook the meaning. He continues this thought saying that “In the long run, investing is not about markets at all. Investing is about enjoying the returns earned by businesses.” The long-term investor should be chiefly concerned being invested and earning the cash flow and growth generated by the businesses that he or she owns. The price of this growth and cash flow (to Bogle, “the markets”) will fluctuate and these fluctuations become meaningless over a longer time-frame.

  • “Time is your friend; impulse is your enemy” Bogle urges investors to be patient and to avoid hasty decisions. His advice is similar to the old saw “measure twice, cut once”. In other words, once we’ve started on a solid long-term investment strategy, the best thing we can do as investors is to let time and compounding work for us. Getting impulsive and changing strategies (“the enemy”) can do huge damage to our returns. 

  • John Bogle began thinking about index investing back in 1951 hinting at the idea in his Princeton thesis. The basic concept of index investing is to ignore trying to sort out “good stocks” from “bad stocks” and simply buy a diversified group of stocks as inexpensively as possible. In other words, “Don’t look for the needle in the haystack. Just buy the haystack!” It often sounds promising to try to find the best stocks, and many investors do exactly that. However, this means that the best companies often have the highest stock prices, making them not necessarily the best investments. 

  • Our favorite Bogle quote gets straight to the heart of our investing philosophy at Svane Capital. “Your success in investing will depend in part on your character and guts, and in part on your ability to realize at the height of ebullience and the depth of despair alike that this too shall pass”. Of course we must understand and focus on the long term characteristics of markets and use appropriate investing strategy. But we must also understand the normal short term behavior of markets, and use this to our advantage when possible. Day to day, and even month to month price action in markets, can be thought of as mostly random with inevitable swings from extreme optimism to extreme pessimism. It is at these extremes where the greatest opportunities are found. At these points the right decisions can feel scary or even wrong. Using these times to our advantage depends mainly on our courage, discipline, and understanding that they don’t last forever.

John Bogle had been thinking about the concept of index investing since writing his thesis in 1951. But he credits support received from Nobel prize winner Paul Samuelson, Charles D. Ellis, and Princeton Professor Burton G. Malkiel in creating a business to capitalize on the idea. 

Bogle founded The Vanguard Group in 1975 launching its first index fund in 1976. In 1996 he retired as CEO, but the company he started continued to grow into one of the largest mutual fund companies in the world today.  Two of his most popular books are “Common Sense on Mutual Funds”, and “The Clash of the Cultures: Investment vs. Speculation”.

Sources: www.johncbogle.com, www.vanguard.com, www.investopedia.com

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

The Long and Short of it

Valuation matters most in the long run...

...but other stuff happens in the meantime

Benjamin Graham famously said “In the short run, the market is a voting machine, but in the long run it is a weighing machine.” A voting machine counts votes. Votes are based on sentiment of people at a given time. Sentiment can change as narratives come and go and is difficult to measure accurately. A weighing machine is much more precise and accurate. The metaphor suggests that in the short term prices are driven by sentiment and the “story of the day”, while in the long term, trends are driven by something you can measure more concretely, valuation.

The overlapping wave graphic above is a simplified picture conceptualizing the interaction between the long term valuation (weighing machine) reversion cycle, and the shorter term narrative (voting machine) cycle. Obviously, this is an over-simplification as the cycles are anything but regular and perfectly predictable, but it demonstrates graphically some important concepts. A few comments:

  • The valuation reversion, or full market cycle is long. Typical equity market cycles follow the business cycle and are 7-11 years. Interest rate cycles tend to follow an even longer generational cycle at 60-70 years. The sentiment or narrative cycle is shorter, typically with a duration less than three years. 
  • It is the longer cycles that “matter more”. Valuation cycles tend to be bigger from bottom to top than sentiment cycles. They are also easier to quantify. Both of these factors are important to us. Buying relatively undervalued asset classes, and then holding them until they are overvalued is a major component of our strategy.
  • “Stacking” of sentiment and value cycles generates the highest highs and the lowest lows. Major buying opportunities always show both demonstrably low historically valuations and terrible investor sentiment. Market tops always show the opposite. Both high prices relative to historical ranges, and also investor optimism that more gains are just ahead.
  • Superimposed on top of the cycles is the constant injection of new information with a large degree of randomness. In the very short term (day-to-day, week-to-week, and sometimes month-to-month), markets routinely do “interesting” things. After the fact, some can be explained, and some can’t. Financial media frequently user the terms overbought and oversold to mean nothing more many days or weeks in a row with prices trending in the same direction.
  • The long term upward bias (due to the market internal return) is not shown in this simplified cycle model. Keep in mind that stocks represent companies that generate profit and bonds generate yield. This return is independent of the cyclical price variation on top of the return. Therefore, these lines should be visualized as sloping upward to the right. This is the feature leading to likely gains for patient buy and hold long-term investors from any starting point, given enough time.
SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. ALTHOUGH BOND FUNDS MAY PAY HIGHER YIELDS THAN OTHER FIXED INCOME INVESTMENTS IT DOES NOT NEGATE THE FACT THAT THE MARKET VALUE OF ALL BONDS FLUCTUATE DUE TO INTEREST RATE MOVEMENTS AND OTHER FACTORS. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. IN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GRATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.
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Lowest Interest Rates in 5000 Years?

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Positive interest rates are such an embedded cultural norm that Wimpy’s offer to Popeye, written by E.C. Segar in 1934, that he’d “gladly pay him Tuesday for a hamburger today” was often heard nearly a century later. And it never lost its hilarity and relevance as a wisecrack…until now. With over $7.8 Trillion (and growing!) in negative interest rate loans in the global market place today, it’s as if investors the world over were flocking to Popeye’s restaurant begging to pay right now for a hamburger next week. If we bought hamburgers with $7.8 Trillion and stacked them up, we could eat hamburgers all the way to the moon. It’s an incredible sum paying for the privilege of being lent. “Please take my money, I’ll pay you when you decide to give it back.” You can’t make this stuff up. Milton Friedman would roll over in his grave.

This note focuses on the history of interest rates and the consequences of changes in interest rates levels. There is an effect on both asset prices and portfolio strategy. We first take a (very) long term look at interest rate history and where the current levels are relative to that history. Then, we discuss three important investment implications of very low historical rates and briefly touch on some portfolio strategies we can use. Future notes will focus more directly on strategy.

Interest Rate History

Interest rates are low now and have been falling for thirty-five years. But before that 1981 peak, interest rates rose for thirty-five years. In order to put things in perspective, let’s take a very long look at American 10-year Treasury rates. This is the interest rate paid by the United States government on money borrowed for a period of ten years with a bond issued in exchange for funds. Below is a chart attributed to Bank of America Merrill Lynch’s Michael Hartnett (and the research team at BofA ML).

During this period Hartnett references five different rate change periods 

1790-1902: Erratic yield fluctuations and then a sustained decline in yields to below 3%.

1902-1920: The First Bear Bond Market, yields rise from 3% to 5-6%.

1920-1946: The Great Bull Bond Market, yields decline from 5-6% to below 2%.

1946-1981: The Second Bear Bond Market, yields soar from 2% to above 15% during 1981.

1981-present: The Greatest Bull Bond Market, as yields tumble from 15% to 1.4% in 2012 (and under 1.6% earlier this year).

However, we can “zoom out” even more! Last September Business Insider’s Elena Holodny presented an even longer term chart (this one prepared by Bank of England and Global Financial Data). 

Andy Haldane of the Bank of England provided the following annotated list of key historical episodes and the corresponding interest rate of the time:

3000 BC: Mesopotamia: 20%

1772 BC: Babylon, Code of Hammurabi: codified earlier Sumerian custom of 20%

539 BC: Persian conquest (King Cyrus takes Babylon): rates of 40+%

500 BC: Greece, Temple at Delos: 10%

443 BC: Rome, Twelve Tables: 8.33%

300-200 BC: Athens/Rome, first two Punic Wars:  8%

1 AD: Rome: 4%

300 AD: Rome, under Diocletian:  15% (estimated)

325 AD: Byzantine Empire, under Constantine:  limit 12.5%

528 AD: Byzantine Empire, Code of Justinian: limit 8%

1150:  Italian cities: 20%

1430: Venice: 20%

1490: Venice, (Leonardo da Vinci paints "The Last Supper in Milan): 6.25%

1570: Holland, beginning of the Eighty Years' War: 8.13%

1700-1800: England: 9.92%

1810: US, West Florida annexed by the US: 7.64%

We see that global interest rates are currently at or very close to the lowest interest rates in 5000 years. Certainly the interest rate “ride” of the past 35 years looks like a historical anomaly and unlikely to continue indefinitely. What are we to make of this and what are the implications to us as investors?  

Investment Implications

Think of interest rates as the “price” of borrowed money and also correspondingly as the rate of return on loaned money. More borrowers and less lenders means rates go up. More lenders and fewer borrowers mean rates go down. 

Declining interest rates also mean increasing bond prices. For example, if we were to buy a 10-year US Treasury bond yielding 5% and the 10-year US Treasury interest rate subsequently fell to 3%, the market price of our bond would increase (because in an open and liquid market trading at 3% would mean that the price of each similar bond would adjust up or down until a buyer of any of these similar bonds would earn the same 3% market rate.)

The following example from thismatter.com shows the effect of interest rate changes on bond prices (in this case a bond with a coupon of 6%:

“Bond prices — not including accrued interest — vary inversely to market interest rates: bond prices will decline with rising interest rates, and vice versa. Bonds with longer effective maturities, or durations, are more sensitive to changes in interest rates, as can be seen in the diagram below, showing the price/yield curves per $100 of nominal value, as the market interest rate varies from 1% to 16%, for a bond with 3 years left until maturity and one with 10 years left, both with the same 6% coupon rate and paying interest semi-annually. Note that both curves intersect at $100 when the market yield = coupon rate of 6%.” (thismatter.com)

If you are with me so far, here is first of three important observations for investors:

Over the past 35 years, fixed income (bond) investors have greatly benefited from the general decline in interest rates because they have earned the yield of their investment PLUS the price appreciation of the bond due to falling interest rates.

When we look at a broad measure of the US bond market (in this case the Barclays Aggregate Index), we see historical annual returns on bonds exceeding 8% since 1980. This represents the combined return of both the bond yield and the price appreciation that occurred as interest rates fell. 

The US Federal Reserve (Fed) began the process of inching rates back toward what they consider as long-term normal last November. The Fed estimates short term interest rates in the 2%-3% range (roughly equivalent to the long term inflation rate) to be the longer term steady state level. This roughly corresponds to US Treasury bonds yielding something like 4-6%. Currently the 10 year US Treasury yield at 1.9% is more than 3% below the mid-point of this range. 

If interest rates trend upwards towards this longer term steady-state range, investors could expect to again earn the bond yield plus the price appreciation due to declining rates. But as interest rates rise, this price appreciation is now negative rather than positive. So fixed income investors find themselves between a rock and a hard place. With Treasury bond interest rates below the rate of inflation, the offer little return and with little room for rates to fall further (pushing up prices). If rates simply remain where they are today, meager yield offers very little investor return. If rates rise, this small yield offers little cushion against the accompanying decline in bond prices. At minimum, today’s bond investors have little reason to believe that their forward-looking returns will resemble recent historical returns.

And now the second point. The interest rate impact on asset prices has not been isolated to bonds.

As rates have fallen many other asset prices have also benefited via substitution and financing effects. This means that these other classes of assets (like stocks and real estate) have also had the advantage of an interest rate tail-wind in recent decades.

As an example of the substitution mechanism, imagine a recent retiree faces an investment decision. She can either buy a 5-year Treasury Note paying a 5% yield (as was common just a few short years ago) or invest in the stock market with obvious additional risk in the hopes of achieving additional return. Her choice would depend on her need for income, risk preferences, and overall financial situation, but a reasonable approach would be to own some of each of the options as many actual investors have done for years (i.e. a typical 60/40 stock/bond portfolio). Now what happens when the bond pays close to 2% and our same investor has the same need for return and yield? It gets much more tempting to “reach for yield” and increase the percentage allocated to the stock. 

Extend these types of substitution decisions across the global asset market place, and we can certainly understand how declining yields in one area of the market could affect prices and yield in other areas of the market. Data seems to confirm this effect. Using the same post 1980 time-frame as before, see the following chart of S&P 500 earnings yield and 10-Year Treasury yield over time:

Keep in mind that as stock prices increase for a given level of earnings, the earnings yield will decline since it takes more money to buy the same amount of yield.

We can also derive financial transmission mechanism from lower interest rates to higher asset prices based on borrowing prices. For example, a house is typically purchased with a fixed rate mortgage. Putting 20% down and assuming a 30 year fixed rate mortgage, a $250,000 home could be bought for a monthly payment under $1000 at a 4% mortgage rate. However, if mortgage rates were to rise toward 7%, the same monthly payment would only buy about $180.000 worth of house (assuming other variables stayed constant).  Data upholds this directional relationship as a national home price index rose roughly 400% since 1980 as interest rates fell from over 18% at their peak.

Another example of financial transmission would be an institutional investor (think bank or hedge fund or manufacturing company) with a borrowing cost of 5%. If an investment opportunity yielded an expected return of 8%, the investor could borrow at 5% and earn the spread of 3% (8%-5%) between the investment return and his cost of borrowed funds. If the investor’s borrowing costs fell to 2% due to a general decline in interest rates, the “hurdle” or necessary expected return, falls also. So this investor could now afford to pay more for the same opportunity because even a 5% expected return yields the same 3% expected spread (5%-2%). Thus substantial and sustained changes in interest rates permeate the economy as a whole providing capital gains to current investors and reducing yields (and expected forward-looking returns).

In addition to these return and asset price effects of a prolonged period of declining interest rates, there is also an important portfolio strategy implication. 

During periods of very low interest rates risk reduction is difficult. Volatility often rises while traditional diversification may be both costlier and less effective.

It has been shown that when interest rates are low, asset correlations (statistic measuring how closely the direction of movements are “linked”) and volatility often increase (statistic used to measure risk). Increased correlations mean diversification provides less “bang for the buck” because a portfolio of assets that move independently of each other provide risk reduction, whereas if the asset prices increasingly move together (increasing correlation) the portfolio risk becomes closer to simply the sum of each asset’s risk, reducing the benefits of diversification.

Furthermore, as interest rates decline, the loss of equity risk premium (the additional return historically available to stock holders in excess of the return available to bond holders) becomes proportionally more important. Note that the following table is for mathematical illustration alone and represents neither actual past or expected future returns. If stock and bond returns were separated by a 5% equity risk premium, we can compute the returns of a 50/50 mix of stocks and bonds at various rates returns. Of course this is a complex and non-linear relationship, in real life. However, the point here is that in a low general interest rate environment, alternative sources of return (for example, the equity risk premium in this case) grow increasingly important.

Tacking Into Possible Headwinds

In summary, we can draw a few specific conclusions:

•    The investor experience of the most recent 35+ years since 1980 was relatively unique within a long span of history because of the magnitude and persistence of interest rate declines over that period.

•    Based on historical data, this seems unlikely to continue for much longer. In fact, it appears that this downward trend in rates is likely to at least end and possibly be reversed in the future.

•    If this historical interest rate tailwind subsides, or potentially reverses into a headwind, asset classes that benefited previously from the downtrend in rates will at least have this advantage removed and could potentially face an interest rate disadvantage for some period of time.  

All of this has a somewhat negative tone, and it is important to note that the outlook is not negative at all for the investor willing to think outside the box. Using longer-term mean reversion among asset classes is important. Certain areas of emerging markets and commodities look historically undervalued. The recent trends that have left US stocks and global bonds well above long term averages have been nearly mirrored (in the negative form) in many markets ranging from Copper, to Natural Gas, to Oil, to Brazilian, Indian, Chinese, and Russian stock markets. The headlines in the former asset classes are optimistic, and cheerfully hopeful. The news on emerging markets and commodities are scary and negative. The setup in such unloved assets therefore appears quite attractive to the patient long term investor.

Another way to think outside the box involves looking for ways to purchase “insurance” against the under-performance of a specific group of assets. One of the best assets to hedge against “systemic” risk has always been gold because of its nature as a currency, its portability, and its liquidity. In a negative yield world, the fact that gold is just money and doesn’t pay a yield becomes a positive trait rather than a negative one. Other real assets without associated liabilities can serve a similar role. 

Our forward-looking strategy toolkit includes:
•    Using long term mean reversion concepts to look for unloved and under owned assets.
•    “Store-of-value” type assets with inverse correlations to traditional financial assets.
•    Taking advantage of expected increased volatility by raising cash balances and deploying into market sell-offs.
•    Limiting exposure to relatively overvalued areas of the equity markets.
•    Reducing bond exposure and minimizing the duration of bond holdings.

At some point in the future interest rates will approach a more viable level. Until then, we need to be aware of the headwind potential, nimble, and ready to engage in tacking into the wind. Taking a macro view in the search for undervalued and unloved assets (particularly ones with low correlation to our other holdings) is always good investing strategy. We plan to continue this discipline under all circumstances.

References

BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg, 2016

Business Insider, 2015, <http://www.businessinsider.com/chart-5000-years-of-interest-rates-2015-9>

Business Insider, 2015, <http://www.businessinsider.com/10-year-us-treasury-note-yield-since-1790-2015-2>

Haldane, Andrew, “Growing, Fast and Slow” Bank of England 2015

https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/the-expected-real-interest-rate-in-the-long-run-time-series-evidence-with-the-effective-lower-bound-20160209.html

http://www.calculatedriskblog.com/2013/06/house-prices-and-mortgage-rates.html

MULTPL, 2016, <http:// www.multpl.com> (Chart Data)

Bankrate, 2016, <http://www.bankrate.com>

 
SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. ALTHOUGH BOND FUNDS MAY PAY HIGHER YIELDS THAN OTHER FIXED INCOME INVESTMENTS IT DOES NOT NEGATE THE FACT THAT THE MARKET VALUE OF ALL BONDS FLUCTUATE DUE TO INTEREST RATE MOVEMENTS AND OTHER FACTORS. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. IN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GRATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

  

Short Squeezes & Apple Juice

Have you ever found yourself between a rock and a hard place? How about caught in a vice? Being in a squeeze is an unpleasant experience, but in a market short squeeze, it all depends on one’s perspective. 

In mid-January, we couldn’t find more than a handful of optimistic perspectives on oil, industrial metals, emerging markets, or gold. It wasn’t for lack of looking. The consensus opinion was that the bear markets might never end. Prices would decline, and then decline some more. But since those lows Brazilian & Russian equities have jumped 35% and 28% respectively, oil has increased 38% while gold rose 22%. Aluminum producer Alcoa surged 54% with miner Freeport McMoRan running up 186%!  Why? Mainly because eventually everyone that wanted to sell at those prices got done selling. Then buyers that had been watching and waiting to take advantage of even lower prices, suddenly had to compete against each other. In market terminology, what happened is known as a squeeze. 

Imagine a market where each day apple growers bring apples to sell and where apple juice-makers purchase their daily supply. Suppose that one day one of the growers announces that she has had a plentiful harvest and needs to sell two full wheel barrows rather than her usual one. She begins reducing her price to sell the first load quickly. Some juice-makers buy the apples they need, but as the price continues to drop they also buy enough apples for tomorrow and then head back to the shop. But one juice-maker sees the price dropping and decides to wait for the arrival of the second wheel barrow, when surely he’ll be able to purchase all the apples he needs at even lower prices. The price continues to drop as other fearful apple growers reduce their prices. Afraid they may not be able to sell all of their apples, they hurry to sell as quickly as possible and are willing to accept lower and lower prices. Compounding this, many buyers have already left the market having bought as many apples as they could cart back. Anxious sellers, and dwindling buyers continue to drive prices lower. Then our original fortunate grower returns, wearing a long face and carrying just one small bucket. Birds have eaten her remaining apples while she was away, and she only has a few left to sell.

Of course, we know the rest of the story…she sells her remaining apples at a price dramatically higher than the original price. Our opportunistic (greedy?) juice-maker is squeezed! He has to outbid the rest of the market, regardless of price, in order to purchase the apples needed to run his business that day. The fortunate apple-grower has sold a few apples at a high price, but a whole wheelbarrow at low prices. Fearful apple growers have regretfully sold their production at losses, but some wise, value-sensitive juice-makers have ensured themselves of not one, but two profitable cycles of production.

The moral? Market participants should avoid competing with frenzied herds of either buyers or sellers. Buying value is wise, but trying to buy the bottom, or sell the top is hazardous.

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