33:1 – A Landslide for Fixed Income

Now that we have just finished our quadrennial exercise of picking the occupant of the White House for the next four years (at a cost of around $2bn this round), it is time to look at how investors have been voting with their money over the last five years. With the reelection of President Obama, it is tempting to think that circumstances will continue on as they have over the last four years. That may be true of the American political system but the Global Financial Markets are poised for a change.

In a report by Pyramis Global Advisors (you can get the report through this link), the authors note that net investment inflows since the end of 2007 to now have been $1.1trillion into bonds and $33bn into stocks. Lest you think that the bulk of the discrepancy happened during the market meltdown in 2008, a chart on the front page shows that most of the inflows occurred in 2009 and 2010 when equity markets were largely on the mend. The rate of inflows has varied slightly in the last two years as the markets have see-sawed between “risk-on” and “risk-off” trades but the overall direction of money has been solidly towards the fixed income side of the ledger.

That suggests two important concepts that will help us spot any sustained change in the capital flows. First, while the Global Financial Crisis (GFC) certainly raised risk awareness, investors continued to be spooked throughout the “recovery” period. Second, it shows that despite valuation models which show many classes of bonds to be at or near bubble valuations, investors will continue to plow fresh capital into a favored asset class.

Why don’t institutions “Fight the Fed”?

The reason for this outsized charge into bonds over equity can be traced to the hyperactive central banks of the US, EU, UK, Japan and China. At nearly every crisis point, the solution has been to lower interest rates, buy up or lend against toxic assets at above market prices, manipulate the yield curve and generally to loosen monetary policy. Unlike the Greenspan Era, Chairman Bernanke has been crystal clear about his monetary objectives. While economists and other market pundits can bemoan the bubbly prices, national solvency and inflation risks that such policies engender, bond investors and traders have plowed more money into bullish trades to take advantage of the historic circumstances.

What the report suggests

The report leads the reader to the conclusion that valuations will win in the end. And, if one does not worry overly much about time frames, that conclusion is correct. Investing at lower valuation points in the cycle has been demonstrated to increase the odds of superior investment returns in the subsequent decades.

Unfortunately, that does not leave much for those of us looking to invest now.

Will things change?

Yes, despite the best efforts of the Federal Reserve and other central banks around the globe, the economic cycle has only been delayed, not suspended. Once a real recovery is established and well identified, we should see a shift of funds into equities at the expense of fixed income and idle cash. Interest rates and inflation rates will put pressure on the current status quo. And secondly, most financial bubbles tend to pop as soon as they are starved of fresh capital. Even without a robust recovery, a modest shift in capital flows, due to a change in the US current account for example, could tip the balance for fixed income vs. equity capital flows.

How will we know?

The beauty of the FundLogik Application is that it is designed to monitor the shifts in money flows because those money flows have a direct impact on pricing levels. By monitoring a broad range of asset classes and comparing them to each other, it becomes clear which assets are gaining investor favor. One day, we will see a report showing that the flow of money between bonds and stocks has reversed. Unfortunately that report will come out at least six months after the change has occurred. With the FundLogik Application, you can participate in the shift as it happens…and read about it in the financial press later.

May You Live in Interesting Times

Despite well telegraphed intentions, the Standard and Poor’s downgrade of US Government long term debt still came as a big shock to most investors. The markets have and will continue to react accordingly. Expect high volatility and no small amount of panic.

Economist CoverWith the US economy barely growing (latest reading at 1.6% for 2Q), the next question is the one which we find on the cover of the Economist this week. The magazine and other sources like ECRI are not willing to say for sure that there will be a second recession but are warning that the chances for a double dip are on the rise. The popular image is of the US economy being like a slow moving bicycle…the slower it moves, the more easily it can tip over. Like most easy images, this one obscures more than clarifies. As the impact of the tsunami in Japan on global supply chains demonstrated, the US economy is far more complicated than a bicycle.

Earnings are pretty good

While politicians are doing their utmost to stymie growth in the US, on the earnings side S&P500 companies have turned in positive numbers. In the latest round of reporting, the earnings have grown at just under 18% or about 5 percentage points better than expected. How can the largest listed corporations in the US be earning better than expected profits with the US economy so close to “stall speed”? The magic trick is achieved by non-US sourced earnings which may account for as much as 50% of the total (up from less than 40% before the onset of the Global Financial Crisis). The developing world continues to develop a middle class that is keen to acquire the trappings of their recently improved status.

Valuations are out of line

The dichotomy between the US economy and its leading corporations is part of the reason why there has been a disconnect in the “Fed Model” which compares the interest yield on the current 10 year Treasury to the inverse of the PE ratio (otherwise known as the “earnings yield”). If 50% of the earnings used in the earnings yield calculation are from non-US sources, comparing that result with a less than free market rate on 10 year US Treasuries (thanks to QE2) is an exercise in GIGO (garbage in, garbage out) financial modeling.

What should an investor do?

In the case of risky assets, one should be watching for short term opportunities at this point. SPY is very oversold (see chart) so even though the long-term outlook is unclear, there will no doubt be a rebound as soon as the panic subsides and cooler heads move in to pick up the pieces.

SPY is oversold

Otherwise, continue to monitor the situation from the sidelines. Gold will continue to move up as investors who are extremely risk adverse will look for havens beyond short term US Treasuries. If one thinks about gold as a low inflation currency, it is not hard to fathom its latest appeal. Of the 100 largest ETFs listed in the US, IAU and GLD remain at the top of the rankings. Health Care, Biotechs and Pharmaceuticals are also found amongst the top 20 but the ratings are far from conclusive at these single digit levels.