My Own Analyst

Weekend Update: 2.50% Ten-Year Edition

Rapidly rising rates.  Say that a few times, as the market sure did.  Do we need to worry?  Is 2.5% high?  For some perspective, I shared the two-year chart yesterday on my Invest By Model Blog:

Before we get nervous about a move over the last 11 months from 1.40 to 2.50, let's also look at a longer-term perspective:

10 Year Treasury Rate data by YCharts

Not so scary, right?  In the short-term, rising rates are a reason for fear.  If one takes the time to really think through what's going on, it's not so scary and is likely creating an opportunity.  I have addressed the normalization of rates before.  The key questions are will higher rates slow economy or will they make bonds look attractive relative stocks.  My guess to both is no if this stops near the 3% area that I expect.  More importantly, if the economy shows any signs of being impacted, the Fed will step on the gas again - they are doves and are likely to remain doves.

I gave more thought to the correction.  While I still think 1530-1570 could be the low (1578 printed yesterday), I don't want to be too confident yet.  The lows could be lower and I will continue to monitor.  I also think that the timing is such that we see the low in late July.  60-75 days seems appropriate, and this puts it in the back half of July or early August.  I will, of course, be doing the work to get confidence when a low has appeared to identify it as quickly as I can.  

There are signs of being oversold very slightly.  SPY is -0.20, while QQQ is -.56.  IWM is just -.01 and DIA is -0.13.  Among sectors, it's interesting how those that were overbought are now oversold, with XLU at -1.44 and XLP at -.47.  

Looking at the watchlist ( Download Watchlist062113 ), the number of stocks above the 10dma plunged to 22 out of 100.  Only two double-digit losers:  ANV in the weak gold tape but also APOG, which could be an opportunity.  They report on Wednesday, and my one-year target is 30 (17 PE plus cash).

Oversold names on the watchlist include ANV,SWI and NEM at < -2.0, while those between -1 and -2 include:  VWO, VOLC, TITN, INGR, CPRT, APOG, CLH, EGOV, HRL, CHS, NATI, BEN, LQDT and ANSS.  On the prospects list, those at -1.5 of more that are worth mentioning in my view would include AGN (-2.56), which looks interesting near 90 (stock down on possible competition for Restatsis and also I think VRX buy of Bausch & Lomb) and AAPL at -1.54.

Black 1s are now down to 8 with two black 5s.  Stocks offering more than 35% added a few names:  BEN, SCVL, XEC and EOG, which joined PBI (which I really like), VOLC (which is very interesting), BCEI (which  I like) and ANV.  WAG and APOG report this week.

Looking at the stocks in the models ( Download Positionwatch062113 ), I am selling ATX - it's just 20% to my one-year target and a bit overbought.  We are adding PBI.  I am also trimming LMNX and SMCI and adding to oversold CLH.  In CG/B, I am cutting CSCO slightly and adding back BEN.

Treasury Yields Rising

Igor wants to know what's up with interest rates...

We went through Treasury auctions this week, including the 30-year today and the 10-year yesterday.  The supply was likely an issue, but people are already starting to see the end of Twist (in June, I believe).  With the stock market lighting up and the economy skating away from the risk of recession, bonds are a poor near-term choice.  This doesn't surprise me at all.  

A few weeks ago, I warmed up to gold a bit (added GDX to my Sector Selector ETF) as a hedge against the Fed erring with too much easing.  Gold has performed very weakly along with bonds.  Recall that both of these have really been helped by the "fear trade".  So, this looks like a dose of fear trade reversal combined with supply and the realization of deteriorating technicals (of the Fed buying).

In my Conservative Growth/Balanced model, we have a MINIMUM allocation to bonds, and it's all in lower-duration Mortgages - ZERO TREASURY EXPOSURE.  So, I am loving this action...

Gold, Commodities and Bonds Bend on Bernanke's Testimony

Bernanke testified before Congress today, and I think that investors may be inferring a potential change in the the interest rate outlook.  I don't think that he said anything specific, but I didn't hear the entire Q&A.  Gold is down sharply, and bonds are falling today slightly. The worst sectors in the market today are Materials and Energy.  

I continue to think that the FED is at risk of staying too easy too long - hence I haven't had a problem upping exposures to Energy and Gold in my ETF model and even in Top 20 to some degree.  This just looks like a trade for now, but it merits attention.  At the first sign that Bernanke is open to earlier rate hikes than three years from now, we don't want to be exposed to pro-inflation investments, at least in the near-term.   

Worst. Investment. Ever.

I was going to write an article for the Seeking Alpha community, but I changed my mind.  Here is a graphic I created that I want to share here:

I exaggerated in the title, as the 10-year Treasury isn't the worst investment ever, but it sure is likely to be a dumb one.  I think it has sucked in hedge fund macro types who aren't thinking about the long-term.  It's easy to get sucked into the idea that there is no risk because of Operation Twist, but let's not forget that interest rates rose during QE1 and QE2. 

As I look at the chart of the yield over the past 50 years, I see a parallel to 2009.  Look how far the rate is from the 200dma - rather extreme.  If we continue to see 5% nominal GDP, I would expect rates to rise to about 3%, perhaps higher.  The downside price risk is quite high.  If the yield were to rise from the current 2.07% (on the 2.125 of 8/15/21, which trades at 100.5) to 3.07% over the next 6 months, the price would decline by over 8% (total return would be about -7%).  I guess that's not the "worst investment ever", but it sure stinks.  What if the yield were to rise to 4%?  The price would fall from 100.5 to 85.  Ouch. 

The way I look at it is that one can hold the 10-year to maturity and earn a cumulative 22% if coupons are reinvested.  I think stocks can do that in two years, perhaps sooner with a little luck.  I bet not too long from now, people will be wondering what we were thinking allowing the 10-year to trade below 3%.

Way Off Wall Street GDP Take

Everyone focuses on Real GDP, which is adjusted for inflation.  I have always focused on Nominal, which is the actual number.  Companies report earnings in nominal dollars and pay nominal interest payments on their debt and nominal dividends.

While there will be some talk today about the Real GDP, which grew 2.5%, being a little stronger than it expected (2.3%), I think that the real focus should be on the 5% Nominal GDP growth.  This is the first time it has been this high since Q1 and Q2 of 2010 and Q4 of 2009.  Before that, you have to go back to 2007. 

Why is this important?  A little inflation will go a long way to helping us grow out of this debt overhang.  We have been seeing shifts between real GDP and inflation such that high real GDP prints have been accompanies by low inflation and, more recently, both have been low.  We need nominal growth to pay back all of the nominal debt at the government and individual levels.

The "Goldilocks" scenario is that we can have just enough inflation on an economy that grows in real terms modestly, and today's GDP report smells like Goldilocks.  Markets LOVE Goldilocks...

This kind of report screams to sell bonds.  The 10-year Treasury over long periods of time tracks nominal GDP.  One quarter isn't a trend, but there is tremendous risk in my view to holding long Treasuries if we find Q4 ends up being like Q3.

Bullish News

I am glad I didn't post this earlier, as I don't need to get anyone bullish at the beginning of a day like today, but do be aware that Brazil CUT rates yesterday.  One of the big questions this year would be the potential of the BRICs to step on the brakes too hard.  Emerging Markets rallied on the back of this yesterday and are down just a little today.  I am no expert on this one, but it might make sense to invest in Brazilian debt here - there are funds that do so (or emerging markets in general).  The rates are high and the finances stronger than in the U.S. (seemingly little currency risk in the long-run).

I wouldn't be too discouraged by the action today (I would say I expected it).  While we still have a potential gap to fill, it doesn't have to get filled (though odds are that it does).  I think that it's possible we go to 125.50 or so first.  While I pay attention to the S&P 500 as being more representative than the widely watched Dow 30, it closed up YTD yesterday (barely).  Now it's down a little but up including dividends I think.  In any event, I continue to think that we have a shot at the Hail Mary getting caught (rally to 125.50 and then keep rallying), though the more likely scenario is a test (114-117).  Of course, if it follows 1998, we will make new lows in Sep/Oct, but not by too much.  For now, the 2008 style sell-off seems the least likely still. 

Early Dip to Support

The market didn't get the bounce yesterday I was envisioning after the reversal on the open which I did get.  Today, I see Jackson Hole as a likely non-event.  The SPY has bounced at what I see as likely support for the day near 115.25.  As we know though, the markets can be a lot more volatile than we envision.  Underneath, I see good support near 114.25.  It will end up being a good week if we can close above that level in my view and a great one if we can recapture 117 or higher.  I continue to expect a lot of fits and starts - that's why I posted my fade comments on the open yesterday.  The likely path is two steps forward and one back until we get closer to 125.50 or so on SPY. 

If I had place my best guess on what might happen today a la Bernanke, stocks will likely rally a little, but bonds and gold could get slammed hard.  There is a chance his talk on the economy leads us to believe that the recent "two years" is not set in stone but rather an expectation (which is what I think it is).  In this case, bonds get slammed because they are viewed as riskier and gold likely follows because of the reduced chance of free money forever.  Still, the more likely scenario is a big nothing. 

S&P Downgrade

The sell-off really kicked in two weeks ago, when it became clear that even with a short-term debt ceiling hike, we were likely to be downgraded.  Last night, S&P cut the U.S. rating to AA+ from AAA.  This leaves only Germany and the UK as AAA among the largest economies, with Japan at AA- and China at AA-.  I would expect that Germany and the UK will be cut by S&P as well. 

Who knows if the market will react strongly or not.  It is certainly something that could trigger a knee-jerk reaction, but it's not likely to mean a lot and was certainly expected to a great degree.  The politicians were way wrong about substantially higher borrowing costs in my view.  There could be some dislocations, as many investors require AAA.  It remains to be seen how things play out, but guidelines can be changed and holdings don't need to be sold necessarily, though it could impact new investments.

The real story is that governments around the world are struggling post-crisis.  Europe is in a lot worse shape than the U.S.  Corporate balance sheets generally are strong, the banking system has improved itself over the past few years, Consumers remain pinched and Government debt is a problem.  In the long run, when global economic growth normalizes, the issue becomes less challenging. 

Question on Junk Bonds

Charles asked me what I meant when I described Junk Bonds as "studly".

The point I am trying to make is that the flight to Treasuries hasn't resulted in a widening of the spread between lower quality bonds that we would normally see.  I take this as a very important divergence.  Here is the spread between the yield of the ML High Yield Bond index and the 10-year Treasury since 1994.  The current spread continues its move back towards the lowest levels since the index began:

 

The point is that I would be somewhat concerned by the flight away from stocks towards bonds and towards less cyclical stocks if this measure were confirming.  Alternatively, you can just watch the ETFs "JNK" or "HYG"

Case Study in Dividends Consumed by Tornadoes

Joplin-based electricity (and other utilities) provider Empire District (EDE) plunged today as it suspended its dividend.  I share this as a lesson in investing, as there are many.  First, the news today is several days after the tornadoes - might some quick thinking have led to more selling than the stock initially saw (23ish peak to 22.5ish before the plunge today)?  Second, investing in smaller companies (market cap was about $900mm) that aren't very diversified entails extra risk - be aware.  Third, is the stock really worth 15% less?  Investors were enjoying about 5.7% dividend yield, so today's action seems to imply about three years of no dividends.  The company stated that the suspension is only 2 quarters.  On the surface, this sure seems like a bargain.  That's the third lesson - sellers (and buyers) aren't always so rational.