Home' Trinidad and Tobago Guardian : June 21st 2015 Contents JUNE 21 • 2015 www.guardian.co.tt SUNDAY BUSINESS GUARDIAN
STOCKS | SBG10
in the US,
run for fixed
recent months, some now question the role
of fixed income in a portfolio.
Perhaps the most obvious point to be made
is that bonds are generally believed to do badly
when rates rise, which is scaring some away
from the asset class. This has not been true
historically. Bonds have historically performed
relatively well during rate rises and this article
discusses a recent book on the topic reaching
the same conclusion.
Additionally, the Fed is not yet raising rates.
The Fed is currently predicting a rise in the
second half of 2015. Forecasts have generally
been too early in predicting a rate increase
over the past several years.
There s a tendency to believe that bonds
are expensive currently. It is certainly true
that their yields are below historical norms,
however, we are also in a period of low infla-
tion. Importantly, though the valuation of
equities is less obviously apparent, but one
can argue that equities may be just as expen-
sive as bonds in the US. This certainly appears
to be the case given the US 10 year Treasury
yields 2.4 per cent and the dividend on stocks
is 1.9 per cent.
Both these valuation metrics are well below
historical averages and close to all time lows,
presumably reflecting high confidence in low
and stable inflation in the coming years. There-
fore, to avoid bonds in favor of stocks because
of meager returns, may be shortsighted based
on what informed projections of long-term
equity returns are also forecasting.
Note these apparently high US valuations
for both stocks and bonds may be a reason
to make sure your portfolio is internationally
One of the challenges in portfolio construc-
tion is that there are many sources of incre-
mental return, but they often come at a cost
of greater downside risk. This creates a role
For example, momentum investing, which
is the strategy of holding past winners for a
period of a year or less has performed well
historically and generally beats the market,
on average. However, it also comes with a
cost in that if the market falls, then the strategy
can do much worse than the overall market.
Hence the strategy can make your returns
worse, right at the point when they are weak-
est.A similar principle applies with several other
market anomalies, for example selling out of
the money put options can be profitable over
time, but especially expensive in bad mar-
Against this disappointing backdrop for
many investment strategies in weak markets,
bonds have historically performed rather well.
Government bonds benefit from a flight to
quality effect that can occur in bad markets.
So when markets do poorly, bonds can actually
For example, in 2008 stocks fell 36 per cent
and the US 10-year Treasury rose 20 per cent,
in 2002 stocks fell 21 per cent and the US 10-
year Treasury rose 15 per cent. Bonds don t
always rise as strongly as they have in recent
market declines, but they do normally rise
when stocks do poorly, and show lower volatil-
ity than stocks.
This matters because of the behavioral
aspect to investing. It s easy to believe that
during bull markets you have a strong stomach
for market declines and progressively notch
up your willingness to take risk. However, as
we saw in 2008/9, many previously fearless
investors will move to cash when a large mar-
ket decline hits and they see red in their port-
folio. This is quite understandable, but an
unfortunate for investment returns.
Fortunately, bonds can help make a portfolio
more tolerable in bad markets. They do this
by rising in value when equities are falling
the most. This should help level portfolio
returns, which in turn can help you stay the
course and help your long term investment
When you think of the benefit in terms of
enabling you to stay the course in maintaining
a portfolio, the returns from bonds in bad
markets are potentially significant.
It should also be remembered that bonds
are generally an extremely low volatility invest-
ment if held for the longer term.
For example, if you hold a US Treasury 10-
year bond for the entire 10 years, and there
is no government default (which appears
extremely unlikely) then you will earn precisely
the payment promised when the bond was
issued. This level of certainty is rare in other
asset classes. Of course, changes in the mar-
ket s discount rate, can change the value a
bond trades at in the interim, but if you hold
the bond to maturity the cash flows will be
Stocks virtually never have this same level
of predictable cash flows because so much
depends on earnings growth and dividend
payouts and these can rise and fall by large
amounts for a sustained period.
This is why we believe bonds are particularly
valuable for those with shorter time horizons.
Certainly bonds have a lower return in most
historical periods, but you are much less likely
to endure a bad short term outcome with
bonds than with equities.
Since 1928 the 10 year US Treasury bond
has never fallen more than 12 per cent in a
calendar year and have had a positive annual
return in more than eight years out of 10, and
again remember that some of those increases
are coming when stocks are weak. Of course,
there is a cost to this predictability in that
the average return on bonds is generally lower
than the average return for stocks.
Owning bonds directly can be challenging
and they can be tax inefficient, but there are
solutions to both.
Firstly using diversified ETFs such as the
Vanguard Total Bond Market ETF (BND) or
iShares US Core Aggregate Bond ETF (AGG)
offers you a broadly diversified pool of thou-
sands of bonds at low cost with both having
a 0.08 per cent expense ratio, and secondly
holding them in tax sheltered accounts such
as retirement accounts can defer or eliminate
tax on the dividends they pay.
The Fed is not raising rates yet, but his-
torically bonds have performed well during
Predicting catastrophe for bonds would be
well outside historical norms over past cen-
turies and bonds, when the worst annual
return was a 12 per cent loss and the general
rule of thumb that bonds will likely level
returns if stocks are weak, and may do this
better than most other asset classes. It appears
bonds deserve a role in your portfolio.
Why you still
need bonds in
Besides the first day of summer, next week her-
alds a potentially negative week for US stocks,
if seasonal patterns hold.
The historic rhythm of a midyear selloff in the week after
June s quadruple witching expiration Friday could make next
week a downer.
Quadruple witching is the quarterly expiration of a variety
of futures and options.
Despite that negative bias, one area of the market has
The final three days of June and the first nine days of July
are typically very positive for the Nasdaq, and the composite
has gained an average 2.3 per cent during that period going
back to 1985. In that time, it s been negative just seven
times. Last year, the Nasdaq rose 1.4 per cent in the peri-
od.According to Stock Trader s Almanac editor-in-chief Jeff
Hirsch, the Dow has been down 22 of the last 25 years in
the week after June expiration Friday, for an average loss of
1.1 per cent.
The S&P 500, meanwhile, has been higher only once in
that week since 2003, but the Nasdaq outperforms, and it
has been up 50 per cent of the time since 2003.
"A lot of times, there s just straight-up seasonality and
recurring market behaviour patterns. Greece and other events
could easily exasperate it," said Hirsch. Hirsch said the June
quadruple witches, like September s, are particularly negative
Traders have been chatting about the negative seasonal
track record and are watching Greece as a possible trigger
for selling if its meetings don t go well with euro zone
"That s clearly the danger. If they start a major run on
the banks, things could turn ugly very fast," said Art Cashin,
director of NYSE floor operations at UBS.
Hirsch notes that June witching is a significant mile marker
for the market, as it comes at the end of the first six months
of the year. (Hirsch calls this a triple witch though on Wall
Street, it s commonly called the quadruple witch.)
Hirsch says every day of the post-expiration week may
not be down to make for an overall negative outcome, and
the selling could also be short-lived.
"There s more bullish bias towards the very end of the
month, and there s still a little bit of June left after next
week. The tail of the end of June into July is something we
call Christmas in July, " he said. CNBC.com
...And why next week may be bad for US stocks
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