On My Radar: I Don’t Know How to Love Him

July 15, 2016
By Steve Blumenthal
I don’t know how to love him,
What to do, how to move him.
I’ve been changed, yes, really changed.
In these past few days when I’ve seen myself
I seem like someone else…

Should I bring him down? Should I scream and shout?
Should I speak of love – let my feelings out?
I never thought I’d come to this – what’s it all about?

Don’t you think it’s rather funny
I should be in this position?
I’m the one who’s always been
So calm, so cool, no lover’s fool
Running every show
He scares me so.

– Andrew Lloyd Webber from Jesus Christ Superstar

We have four interns this summer and today I took them to lunch.  One asked what I wrote about today.  I said the title of the piece is, “I Don’t Know How to Love Him” and, of course, they gave me a funny look.

I asked them if they had ever heard of the Broadway musical, Jesus Christ Superstar.  Unfortunately, the answer was no.  At the start of their internships, we required that they read “How the Economic Machine Works” by Ray Dalio.  The paper discusses how central bankers have certain levers they can pull, such as raising and lowering interest rates and other tools to speed up or slow down the economy.

I told them that I’m thrilled our fixed income strategies are doing well yet the unprecedented central bank experiments have so distorted price discovery that I just don’t know if I should scream or shout.  I’m concerned that the Fed has boxed itself into a Keynesian corner and, thus, the title of today’s piece.

Stuck in an academic theory.  Stuck in groupthink.  “Running every show.  He scares me so.”  Therefore, on guard we stand.

Last week, we looked at valuations — probable 3, 7 and 10-year forward returns.  I think you’ll find the following chart from Research Affiliates, as I did, quite interesting.  It shows their forecast for coming 10-year annualized real returns (net after inflation) on various asset classes.  RA adds confidence bands around their predictions (the red arrows are mine).

7.15.1

Well, holy cow!  Not so good.  U.S. Core bonds at less than 1%, U.S. large-cap equities at 1% and 60/40 at 1%.  I appreciate that Research Affiliates included confidence bands in the chart.  The colored dots are the expected real returns and the vertical line shows the high end and low end of the probable outcome ranges.  Results could come in a bit higher or a bit lower from the dots marked by the red arrows (expected outcome).

If you missed it, click here for a link to last week’s OMR for more on current valuations and what they tell us about coming returns (and risk).  You’ll find that we pretty much get to the same place.

I also liked the next chart.  It shows the starting yields as of June 30, 2016 for various investments.  You’ll see that high-yield bonds look relatively attractive and to that end HY has had a great run.

7.15.2

Look at that high yield real yield percentage.  I’ve been trading the trend in HY for over 23 years.  We know high yield well.  Don’t go “all in.”  The chase for yield has flooded investor capital into HY bonds and funds.  This has enabled companies (I call them zombie companies) to receive funding that they otherwise would not have and at terms that should scare every investor.  The next recession will wash them out.

You can find the link to RA’s charts and further commentary here.

I told the interns that HY credit quality has never been worse.  There is little protection and high risk in that 6% yield.  We are invested in HY today.  A generational trading opportunity will present in the next recession.  Think a 20% yield opportunity versus 6% today.  I told them how important it is to not get run over on the way to that opportunity. Stay tactical.

I just can’t help finding myself thinking about the Fed and QE, the EU and QE, Japan and QE, ZIRP and NIRP and wondering how they are going to get out of the corner into which they have painted themselves.  The lyrics “I don’t know how to love you, I don’t know how to use you… He scares me so,” keep running through my head.

Former Fed President (Dallas) Richard Fisher appeared on CNBC this week.  I like his candid way.  You’ll find some brief notes below and a link to his interview.  Lacy Hunt is out with his quarterly letter.  Always a great read.  I share a few highlights, a link to his letter and my thoughts below.

In the “what can you do with your fixed income exposure” category, I wrote a piece this week for ETF.com, “The Zweig Bond Model – How It Works.”  I noted that Wall Street analysts missed the 22% gain in longer-dated Treasury bonds this year.  They completely missed the rally in bonds in 2015.

In December 2014, the consensus (25 out of 25 Wall Street economists) predicted interest rates would rise from 2.75% to 3.25% by the end of 2015.  They missed.  The 10-year Treasury note finished the year with a yield of 2.25%.  Can you imagine the trillions of dollars that followed those recommendations to shorten bond maturities?  No small miss.  We touched 1.38% last week and sit near 1.50% today.

The trend-following Zweig Bond Model stayed invested, suggesting longer duration exposure over that time frame.  It continues to signal positioning in longer dated high quality bond exposure.

Each week you can find the Zweig Bond Model in Trade Signals.  It is a process you can do on your own.  I suggest considering ETFs, such as longer-term dated ETFs on trend based buy signals and own shorter-term dated ETFs such as “BIL” on sell signals.  I’m not sure how else to navigate the period ahead given today’s ultra-low rates and central banker determination to inflate economies.  You can click here for how the Zweig Bond Model works.

The mother of all bubbles is in the bond market.  I believe we have to think differently about investing especially in regards to fixed income exposure.  There are ways to navigate the path ahead.  Nothing in this business hits 100% all the time.  Period.  However, trend following works!  I share some insights with you today, along with links to further research.

The Fed and their global central banker friends want to manufacture inflation and ultimately they will win.  The problem will be getting that inflation genie back in the bottle once she’s out.  We need to think differently now more than ever.  If you are interested in learning more about trend following, see the section, Trend Following Works!,  you’ll find a link below.

Finally, last week I promised a look at the latest recession watch data.  You’ll find a few of my favorite “recession watch” charts when you click through to the full piece.  In short, there is no sign of U.S. recession.  I’m sticking with my call for a recession to begin within the next 18

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