The professor who influenced me most at Towson University was Richard E. Vatz, Ph.D., who teaches classes in Persuasion and Advanced Public Speaking. Vatz is a short, wiry guy with a bushy mustache and a wicked sense of humor. Thirty-five years ago, he began his Persuasion class by telling us a story about his best friend, Bob. He described how they grew up in a small town in Pennsylvania, were classmates from elementary school through high school, and after sharing several memorable adventures, were both drafted to go to Viet Nam. After boot camp they were deployed and served in the same unit, where after a year of fairly boring service, just outside of a small, Vietnamese village with a name I can’t remember, Bob stepped on a land mine and died in Vatz’s arms. By the time he finished the story, the entire class (including yours truly) was openly weeping. Vatz then proceeded, with a smug grin, to tell us that he made up the entire tale, and in one of the greatest teachable moments of my young life, asked us why we believed him. After getting over the shock of this deception, we spent the rest of the class discussing how details, numbers, dates, times, names, graphs, etc., all constituted evidence that was very persuasive. We examine this kind of evidence when we determine who and what we believe. Vatz taught me that the speaker who defines the terms of a debate, and who offers the best evidence, is sure to be the winner. It is a lesson I’ll never forget.
Tuesday served as quite a jolt to investors. The S&P 500 lost -1.5%, its biggest drop since last December. It seems that everyone had gotten quite used to the gentle drift higher that characterized the stock market so far this year, since there hadn’t been so much as a 1% correction in the S&P since the end of last year.
This column is called, Echoes from the Pit, not Conversations from the Pit, but I thought you would be enlightened by an actual email string from last week regarding Fed intervention in financial markets. This kind of conversation happens daily as Pinnacle analysts try to reach consensus on how to tactically allocate our strategies. I think you will find the exchange helpful in better understanding how we make investment decisions.
Pinnacle has various defenses built into to how we manage our portfolios. We live by the two unbreakable rules of keeping diversified and avoiding overvalued assets. In addition, we also look to keep various hedges in our portfolio to defend against adverse conditions that have the potential to rattle financial markets. Over the last few quarters we’ve owned treasury bonds to hedge against deflation taking hold, gold to defend against money printing and currency debasement, and the dollar to hedge against continuing risks seeping out of Europe. Today we’ll be buying a few points in oil to defend against the possibility that geo-politics creates a price spike in oil.
Oil, and more specifically gasoline, has been in the news recently. Will $4 or $5 gasoline kill the consumer one more time? For the moment it seems the improving jobs picture is helping to insulate the consumer, but at some point there will come a choking point. With that said the price chart for oil looks like it’s heading higher.
Consumers of investment management might consider three different methods to analyze investment returns. The first method is to look at absolute returns in the context of your financial plan. If the portfolio return was 7% annualized for ten years, was that return high enough for you to achieve your financial goals? What about 3% annualized returns, or 12% annualized returns? Of course, looking through the lens of absolute returns would disqualify negative returns as helping anyone to achieve their goals, so investors often look to other methods to evaluate portfolio returns. Today it is rare to find a manager in any asset class, including hedge funds, who claims to be able to consistently generate absolute returns.
On October 7, 2011, I wrote a blog post describing a bullish divergence forming in the Financial Sector SPDR. I used the Relative Strength Indicator to measure momentum and the price of the XLF to show that although the XLF made a new price low, the indicator did not confirm the drop. I could have used other indicators and equity positions, and the result would have been the same.
We have been patiently waiting for markets to correct and give us a chance to purchase positions that edge our portfolios closer to a neutral stance. But so far this year, the volatility tap has been shut as we continue to watch a slow drift up in the markets. This has tested our patience as we wait for a catalyst to erupt and take some of the froth out of the market.
The duration of a bond portfolio tells you how much the price of your bonds will change for each percentage change in interest rates. A high duration means more sensitivity or price volatility as interest rates change. Duration tells you virtually everything you want to know about the price sensitivity of U.S. government bonds, which are presumed to be risk-free from the standpoint of default risk. Prices of government bonds move with a mathematical certainty depending on the coupon and the maturity of the bonds, both of which go into the duration calculation. Investors increase the duration of their portfolio by increasing the maturity of the bonds they own, and shorten the duration by shortening bond maturities. As you move up the risk-of-default scale from government bonds, you can invest in what is known as “spread products,” or bonds that are priced based on the difference, or spread, in their yield to U.S. Treasury securities. Spread products include mortgage bonds, high quality corporate bonds, junk bonds, and emerging market bonds, all of which typically offer investors higher yields in exchange for a higher risk of default. The price of spread products is not only impacted by their duration, but is also greatly affected by investor’s perceptions of the default risk of the underlying bonds. These bonds are priced on their creditworthiness, and are often simply referred to as credit.