Outside Economics

Now What’s Floating to the Top: Oil, Gold, Equities, or Bonds

Posted by Wendell Brock, MBA, ChFC on Thu, Feb 11, 2016

Talk is, that one of the reasons the market is falling right now is because it was overpriced, which may be the case, however another part of the problem has been that when considering options, where else can you put your money?

Banks aren’t much of an option – at the continuously low rates it makes it pretty painful to leave money there. At least when rates were higher and a depositor could get 4%-6% at a bank you had a fairly good risk free option. Too much cash on the sidelines will certainly cause the market to be bid up. Maybe it’s an issue of supply and demand – there aren’t enough shares to go around, so the prices get bid up.Oil_gold.jpg

Insurance companies, which are very long-term investors, are currently running about 2-4X or more the rate banks are offering. These rates are certainly going to help folks get better returns, with little to no risk. But when chasing performance even those stable rates don’t appeal to everyone. So this week I thought we would look at one reason why the market has tanked over the past several weeks, and consider the option of putting more money in the market – after many of the stocks and bonds are clearly on sale!

Below is a look at why the markets are falling, what is up with bonds, and a check on precious metals.

Why Stocks Went Down When Oil Went Down – Domestic Equities

Equity markets descended in January alongside oil prices, while testing new lows with a visible increase in volatility. Oil’s dramatic price drop has been a catalyst for stock prices heading lower, a so-called correlation that has actually existed for years.

There are various theories as to how oil and stock prices might be correlated, yet one of the most accepted revolves around macro economic global dynamics.

Oil is the most traded and actively utilized commodity in the world whose consumption represents the economic activity worldwide. So when oil supplies grow and demand drops, markets interpret that as an economic slowdown. Such a slowdown thus migrates into the equity markets, where economic activity and growth is essential for expansion and higher equity prices.

Lower oil prices can also be beneficial for certain sectors, such as consumers, transportation and airlines, whose primary expenses are fuel. Economists expect a possible lag effect with recent low oil prices, which may eventually appear on corporate income statements. Obviously, lower oil prices are not conducive to oil industry sector companies, whose margins shrink as oil prices drop.

Some fixed income investors now view U.S. energy stocks as opportunities to earn higher yields on dividends compared to where they were months ago. Lower valuations on energy stocks have led to higher stock dividend yields as prices have fallen.

Does this mean that the markets won’t recover until oil prices go up? For that answer only time will tell…

Fixed Income – Global Bond Markets

The Fed is now at odds with nearly every other developed country central bank as others employ a rate decrease and stimulus strategies.

In its latest FOMC meeting in January, the Fed decided to leave its rate hike plans intact, disappointing markets and lifting U.S. rates slightly. The Fed did acknowledge slightly lower economic growth and volatile equity market conditions as variables to monitor.

International rates fell in January as central banks moved forward with stimulus efforts aided by lower borrowing rates. The ECB and Japan both reduced their key lending rates enough to drive markets in both regions towards risk assets. Japan’s central bank surprised markets by lowering one of its main lending rates into negative territory for the first time in order to stimulate its sagging economy.

Gold and Silver - What's Up?

Considering the markets and the downward trend, it seems that Gold and Silver (precious metals) have come off the winner over the past couple months. Both gold and silver are up, about 14% and 10% respectively. It makes sense to own some precious metals, but as with any investment how much higher will it go? Typically, people own precious metals as a balance to inflation but it can be a stabilizer to an investment portfolio.

With that news, it looks like for the time being, Gold is floating to the TOP! So does this mean we are at the bottom of the current sell off? No, perhaps but not likely. Does it mean its time to put more money in the market and buy while things are on sale? Maybe. Many of these answers are particularly personal to your current situtation that is why a good comprehensive evaluation is valuable.

Sources: Federal Reserve, Bloomberg, Economic Premise #150 World Bank, IMF Research Bulletin, Federal Reserve System Perspective

Remember:

"The hardest thing in the world to understand is income tax." - Albert Einstein

 

Topics: Gold, Oil, Silver, Bonds, equities, banks, Insurance Companies

Fixed Income - Bond Markets

Posted by Wendell Brock, MBA, ChFC on Thu, Oct 29, 2015

Anticipation is building as the Fed nears a decisive move to raise interest rates before year end. Some believe that the Fed may have missed its chance to raise rates, which would have conveyed a sense of confidence about the nation’s economy.

As rates have settled at 50-year lows for sometime now, pension plans are a distinctive few that have not benefited from the low, single-digit rates. This is so because pension funding and growth projections are primarily based on the interest earned. So when rates are low for an extended period of time, growth estimates decline and shortfalls evolve. The concern is that most fiscally strapped municipalities are struggling to meet shortfalls in pensions, thus increasing liabilities and hindering cash reserves.

Credit spreads continued to widen between U.S. government bonds and corporate high-yield bonds, somewhat of an indicator of the credit market’s health.  Questionable corporate earnings tend to pull corporate bonds down, feeding into higher stock volatility and price uncertainty.

Various fixed income analysts are closely following the $1.5 trillion of corporate bonds maturing in 2016 & 2017, representing nearly 20% of the entire $7.8 trillion corporate bond market. Questions arise as to how capable companies will be to pay that debt off, and where will rates be should additional debt be needed to fund maturing bonds.

If the Fed raises rates before year end, the riskier bonds (junk bonds), which have had the highest yields in the past few years, their yields will push higher and prices will fall. Investors should monitor how much they have in riskier paper; they may want to reduce their exposure some in the coming months.

Another area of bond risk is the global high-yield bonds from emerging markets. These have become popular as their yields have been much better than the treasuries. However if rates begin to rise, it is likely they will rise too, as they are in constant competition for investment money. This is one reason why a well-diversified portfolio is helpful. It will limit exposure in any one area and should provide proper cross correlation of investments.

Alternative investments can be a terrific option to add to an income based portfolio, some providing yields of as much as 7.5% or more, with relatively low risk. Because they are hard/real asset backed, the price should not change when rates move. Alternative investments can be a part of well diversified portfolio and provide a base that is typically not subject to market volatility.

 

Sources: Bloomberg, Moody’s, Reuters, Market Watch

 

To Remember 

"God gets to judge; I get to serve." - personal motto of Dell Loy Hansen  

Topics: Bonds, Fixed Income, Federal Reserve, Bond Market

Fixed Income Market - Simplified

Posted by Wendell Brock, MBA, ChFC on Thu, Jul 10, 2014

Recently, I came across a great explanation/story about how bonds worked and I added an element that explained how derivatives worked.  I have never had a drink, I think the story is rather funny simply because I have over the years been to many business parties where the booze flowed rather freely and I could imagine this sort of thing happening.DerivativeAlgorithmic Trading

Bond and Derivative Market

An Easily Understandable Explanation of Bond Markets

Heidi is the proprietor of a bar in Detroit. She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi's "drink now pay later" marketing strategy and, as a result, increasing numbers of customers flood into Heidi's bar. Soon she has the largest sales volume for any bar in Detroit.

By providing her customers' freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for whiskey and beer, the most consumed beverages. Consequently, Heidi's gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi's borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALCOBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don't really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

Enter the derivatives… a derivative is basically an insurance policy on the bonds that buyers get to help insure that the bonds will one day pay off. These policies are traded too on the securities markets, however they are completely unregulated. Because the policy insures the bond it helps strengthen the bonds’ rating. The unregulated nature of the derivatives allows for the issuing company to extend its self beyond what typical capital requirements of other financial institutions, making these financial instruments extremely risky. (The greater the risk, the greater the reward; natural risk and return economics.)

For example a bank typically has a leverage ratio of 8-10 percent capital so for every $1,000.00 they lend they keep $80-100 or a ratio of 10:1 or 12:1 in what is called tier-one capital. However some of the derivatives were written by institutions whose capital level was extended to as much as 40:1 on up to 100:1; so they were keeping as little as $10.00 for each $1,000.00 they insured. Derivatives are not offered by your typical insurance companies.

Now for the rest of the story…

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. He so informs Heidi.

Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since, Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALCOBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks' liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Heidi's bar had granted her generous payment extensions and had invested their firms' pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her whiskey supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations. Her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

The size of the world derivative market, as of December 2013, is $710.182 Trillion; The world economy is $72-85 Trillion, the US economy is only $17.02 Trillion, it is an extremely big market!

The investors turn to the insurance companies who insured the bonds and demand that they too pay up, however because they did not keep enough capital to cover such large losses they implode and seek a bail out to keep from laying off thousands of employees and to keep the world markets open. After all without insurance on the bonds, no one would buy the bonds in the first place (even government bonds) and thus capital flows would completely stop. Totally crippling not just Heidi’s community of Detroit, but the world as we know it!

Fortunately though, the bank, the brokerage houses, insurance companies and their respective executives are saved and bailed out by a multi-billion dollar cash infusion from the Federal Reserve Bank and the Government.

The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-alcoholics.

If you want check if your portfolio holds derivatives let us know by clicking here.

Note: I could not find the original author of the story about Heidi's Bar to give proper credit; I added several paragraphs because the original story did not actually talk about derivatives - just bonds.

Topics: Bonds, Derivatives, Bailout

Alternative Investments

Posted by Wendell Brock, MBA, ChFC on Thu, May 01, 2014

With bonds yielding almost nothing and stocks looking fully valued by most measures, investors need more choices. Fortunately, they’re out there. For decades, the biggest institutional investors have used alternative investment strategies to generate higher returns, with less risk, than standard portfolios.  Today, most of these strategies and asset types are available to Main Street, often through ETF’s or mutual funds or similar investor-friendly formats. But, like any investment, you need to inform yourself.alternative assets

Master Limited Partnerships

MLPs (master limited partnerships) are a type of limited partnership that is publicly traded. There are two types of partners in this type of partnership: The limited partner is the person or group that provides the capital to the MLP and receives periodic income distributions from the MLP's cash flow, whereas the general partner is the party responsible for managing the MLP's affairs and receives compensation that is linked to the performance of the venture.

One of the most crucial criteria that must be met in order for a partnership to be legally classified as an MLP is that the partnership must derive most (~90%) of its cash flows from real estate, natural resources and commodities.  Congress established these special vehicles in the '80s to spur investment in energy infrastructure, and that’s just what this rapidly expanding industry needs today: money for drills, pipelines, and storage, etc. The advantage of an MLP is that it combines the tax benefits of a limited partnership (the partnership does not pay taxes on the profits - the money is only taxed when unit-holders receive distributions) with the liquidity of a publicly traded company.

Long/Short Funds

Long/short funds are the mutual fund industry's attempt to bring some of the advantages of a hedge fund to the common investor. Most long/short funds feature higher liquidity than hedge funds, no lock-in period and lower fees. However, they still have higher fees and less liquidity than most mutual funds. Unlike most mutual funds, long/short funds often require a minimum investment of more than $1,000.

Long/short funds aren't allowed to use as many derivative and short positions nor as much leverage as hedge funds, but they do provide some diversification to the average investor in down markets. Today, several high-quality mutual funds offer access to this strategy but still provide all the usual mutual fund benefits, including daily valuation and liquidity. While these funds won’t keep up with the market during big bull runs, they should significantly outperform it on the downside.

Private Equity

Private equity has been the top performing asset class for big investors for a long time, but it has been a tough area for regular investors to participate in. That’s changing. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a de-listing of a publicly traded entity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet.

The majority of private equity consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public company.

Collectibles

Most collectible assets classes -- memorabilia, jewelry, cars -- should be looked at as hobbies with an upside. These can be fun to get into, but they’re really not suitable for people just looking for returns. This type of investing requires an extremely deep understanding of the particular collectible, the market and the capital. This can be a very illiquid area of investing. I knew a fellow early in my career, who had an amazing collection of over 500 Lugar Pistols, many had been owned by famous people, but he couldn’t sell the collection. A nearly $500,000 investment with no way to convert it to cash.

Art may be an exception. Art has been recognized as a store of value for centuries in almost every civilization, and there are several high quality funds that specialize in this (some even lend out its art to its investors). The trick is to invest behind someone who is both a true expert and an experienced, trusted fiduciary.

Angel Investing

An angel investor or angel (also known as a business angel or informal investor) is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital, as well as to provide advice to their portfolio companies.

Angel investing is exciting but risky. Most angel investors will tell you they expect a return ratio of one third, one third, one third. One third of his/her investments make money, one third go bust, one third plod along. But stats indicate that serious angels can achieve internal rate of return of well over 20%, which is obviously very attractive. Probably the best way into the field for new investors is to join a professional angel group.  To find a group to join, you can go through the Angel Capital Association.

If you’re going it alone, make sure a start-up can clearly explain the problem they’re solving, the solution they propose, why their team can handle it, the size of the market, and what the competition looks like. Two more tips: the first money into a start-up should be from a small “friends and family” round (not from you!). And the second is to be sure to keep more money ready for the next round, because the start-up will need it and you may want to invest more.

Arrow Choices MI resize 600x338

Like any investment, it is important that you know exactly what you are getting involved in and it is critical to clearly understand the exit strategy – how do you get out of the investment? Or how do you cash out? This and the time commitment arvery important, are you committing your money for 3 years, 5 years, or 10 years, the longer the commitment period the greater the return should be. You will want to counsel with an experienced financial consultant who is experienced in the type of investment you are pursuing.

Topics: Bonds, Master Limited Partnerships, MLP's, Collectibles, Angel Investors, Private Equity, Stocks, Institutional Investors, MLPs

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Wendell W. Brock, MBA, ChFC

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