This is the first part of a two-part article on the summer swoon in the markets. Today I consider the inherent contradiction between strong bond and share prices. Tomorrow we’ll look at the fallout.

I try not write too much about the market’s gyrations. For a start, most readers are best off ignoring the noise and dripping money into passive index funds. There’s plenty of importing things to learn about investing, but what’s making the headlines on CNBC is rarely among them.

Also, it’s easy to be wrong when you make economic or market predictions. Being wrong is bad enough when you lose money. It’s doubly hard being wrong in public!

The thing is, I have been an investing genius since March 2009.

Unfortunately, most other people have been, too. Shares, bonds, oil, London property, gold – you name it, it’s nearly all gone up.

We can’t all be right, can we?

Congratulations! You’re a winner!

Regular readers will know I’ve been near-fully invested in equities since 2009. And unlike others who laughed at anyone bullish on shares until the bounceback was well underway and they claimed to be buying, I was consistent – happily posting that the market could be set for a decade of 20%-plus returns in May 2009, for instance.

I got a few things wrong but the main things right, and more than doubled my net worth in under two years. Not bad (try compounding it!) but not very difficult when the FTSE 100 itself rose 73% (before dividends) over the period, and investors like me with a small cap or emerging market tilt did better.

It’s been a genius making machine! And I was barely invested in the supersonic stuff, like oil explorers or gold. Some people have done far better, and can brag of being even cleverer.

But bull markets make everyone look smart – especially this recent market, where you didn’t even have to be very right to make money. While most invested in equities will have done well, the weird thing is so has almost everyone else, provided they dared to tiptoe out of cash.

In particular, US and UK government bonds have generally been a great investment. Corporate bonds, too.

The strength of government bonds has been a constant source of amazement – and reassurance – to me. You see, while the conventional view is that low government bond yields signal recessions, I’ve understood the low yields of the past two years as reflecting investor paranoia, ongoing ultra-low interest rates, and government largesse. All have correctly signaled good times for shares.

The fear part of the equation was certainly evident in late 2008, when US Treasury yields actually went briefly negative – one of my rare good calls on bonds. Otherwise, I’ve waited in vain for a good time to buy gilts, looking for a yield of 5% as far back as November 2009, which seems a reasonable call in retrospect given how RPI inflation has climbed above that level recently.

You’d usually expect bond investors to sell on the prospect of an ongoing negative real yield, to drive bond yields higher to compensate. But that hasn’t happened. In fact, gilt prices stopped falling and started rising, to the extent that the ten-year yield recently fell to 2.76%.

Two point seven six per cent! I can hardly believe it even when I spell it out. It’s a record low.

To buy gilts on such a snail-scraping yield, you need to believe inflation will be tamed, pronto, and that economic growth will be lacklustre, or else you’ll need to buy them for some other reason.

Asset allocation across a diversified portfolio is a good other reason. Bearish despondency isn’t. Speculation by active traders such as hedge funds – about the only money moving the markets nowadays – is another likely cause.

Bonds on a bull run

Of course, you might be buying gilts because you’re the Bank of England implementing quantitative easing. Or perhaps you’re a pension fund forced to buy gilts by dubious regulation.

Either way, a UK stock market that rises 72% even as gilt yields plunge to 2.8%, gold breaches $1,645, inflation tops 5% and prime London property surpasses its pre-crunch highs is a curious conundrum.

• A recovery? Then why are gilt yields so low?
• An inflationary spike to come? Ditto.
• Depression? Then why the equity boom and rising London house prices?
• Stagflation? Ditto.

Now, given the choice you’d rather make your money in pretty safe government bonds where you can be confident of getting your money back1 than in volatile equities. Ergo, if lots of asset classes are doing well at once, you’d rather do well in government bonds and limit your downside.

But does anybody seriously believe that government bond yields will fall further from here – and hence bond yield prices rise still higher? Sure it can happen – look at Japan – but it’s a fearsome prospect.

Earnings, earnings, everywhere

In contrast to government bonds, which haven’t so much climbed a wall of worry as dismissively vaulted it like a skilled practitioner of parkour, equities do not look expensive, even after their recent heady advance.

This graph of yield ratios from broker Brewin Dolphin is pretty revealing:

What this shows us is that the earnings from equities haven’t been more cheaply-rated in the past 23 years, compared to those from bonds. Either people really love bonds nowadays, or they really hate equities

Indeed, the ratio of less than one shows that investors would rather buy the fixed income from riskier high yield US corporate debt (blue line) than the earnings of similar companies, despite the latter’s potential to grow earnings forever into the future, and both asset classes being exposed to company failure.

Investors might prefer bonds because they fear corporate earnings are peaking. A second graph from the same source shows they might (superficially) have good reason to doubt the S&P can sustain its level of earnings:

I say ‘superficially’ because someday even these earnings (black line) will look like molehills against the mountains – total earnings should inevitably go up in the decade’s ahead, if only because of inflation. The mirroring of 2007’s peak is therefore pretty irrelevant – it’s just a dollar number, not a stretched ratio.

What’s more, 2007’s earnings were in retrospect puffed up by all kinds of credit boom frothiness. While doomsters may argue otherwise, I don’t think you can say the same about today’s earnings.

As far as I’m concerned, companies are leaner, meaner, and increasingly draw their earnings from overseas. They’ve worked hard for this income in a housing boom-less, de-leveraging Western world.

P/E ratios for the US and UK also indicate fair-to-undervalued equities to my eyes. True, the longer run Shiller PE 10 ratio (which computes P/E based on 10-year earnings) suggests at least the S&P 500 is over-valued, but unlike many I’m not very convinced by the predictive qualities of that methodology.

In part two: What you, me, and the government should do with our money!

1. So that is gilts and US Treasuries, as opposed to PIIG debt, then [↩]

Not all trackers are as straightforward as good old index funds and Exchange Traded Funds (ETFs). A profusion of less familiar, riskier tracker types skulk in the shadows, beyond the ken of most mainstream investors.

Yet the release of the RBS UK small cap tracker showed that even humble private passive investors may encounter one of these beasts.

So what do we need to know?

Introducing ETNs

Exchange Traded Notes (ETNs) and Certificates are like the grizzly bear and the brown bear of the investing world – one’s of American descent and one’s European, but fundamentally they have pretty much the same snarl. So for simplicity’s sake, I’ll just refer to ETNs for the rest of this article.

ETNs are related to ETFs in that they track an underlying index and are traded on the stock exchange. But there are key differences that make ETNs much riskier than vanilla ETFs:

Like an ETF	Not like an ETF
Tracks an index	They’re debt securities
Trades on the exchange	Can track a single asset e.g. crude oil, volatility
Has ET in the title	Exposed to more counter-party risk – up to 100%

How ETNs work

An ETN follows its underlying index like a train on a track. But where you need to look lively is that ETNs are often used to track exotica like future contracts, volatility indices, currencies or even just half a dozen stocks you might fancy a punt on.

Unlike ETFs, ETNs are not bound by European UCITS regulations that require an investment vehicle to follow a diversified benchmark. So you can indulge your tastes for the weird and wonderful with all the added spice and risk that entails.

An ETN doesn’t actually own the assets that physically comprise its index. Instead, like a synthetic ETF, it uses investors’ cash to buy a derivative.

The derivative is calibrated to pay out the return of the index minus the ETN’s fees. Hence it simulates owning the constituents of the index without the expense of trading in the stuff.

In tandem with the remit to concentrate on single assets, that makes ETNs an inexpensive way of tracking otherwise illiquid and inaccessible markets.

But while an ETN sounds as handy as unmanned space probe to Saturn, the downside is it can come apart like Beagle 2. The derivative payments are made by a counter-party (usually a giant investment bank) and if it blows up then the haircut is likely to be a skinhead. (More on this below).

Many ETN factsheets will mention that the product tracks its index at a ratio of 1:1. This means that there is no leverage involved in the investment and a 1% increase in the price of the underlying asset translates into a 1% increase in the price of the ETN.

If the ratio isn’t 1:1 then you’re double-downing with leverage and piling on the risk.

Getting into debt

ETNs are a debt instrument: in exchange for your cash, you get a promise that the issuer will pay you a return in the future. That has a number of implications for the ETN feature set:

• ETNs often have a specific maturity date like bonds.
• The return is only paid out on that date.
• The return is the value of the index (minus fees) on the maturity date.
• Dividends may or may not be included.
• Dividends are included if the index is total return (TR).
• Income distributions aren’t paid before the maturity date.
• ETNs without a maturity date are described as open-ended.
• If the counter-party goes bust then you’ll have to join the queue of other creditors demanding their money back.

ETNs are often said to be unsecured debt, but in fact many of them are backed by collateral.

Collateral is the air bag protecting you from the impact of a default. Without collateral you’re 100% exposed to counter-party risk.

Even if the ETN is collateralised, the amount of collateral held is at the whim of the bank. It could be anywhere from 1% to 100%, unlike ETFs which must be at least 90% backed.

While it’s hard to imagine any of the too-big-to-fails going down in the near future, UK banking regulation appears to be preparing for the day. Moreover, investors in a few Lehman ETNs were wiped out in 2008.

Exchange bait

Although most ETNs don’t actually pay a return until maturity date, retail investors can still make money by trading them on the exchange.

Market makers ensure ETNs trade close to the price of the index by exchanging ETN shares with the issuer for the current value of the index.

However, the perceived credit risk of the counterparty can also influence the ETN’s price on the exchange, potentially derailing it from the index it’s meant to be tracking.

Cheap and fearful

ETN costs will often be quoted as an annual management charge (AMC) rather than a Total Expense Ratio (TER).

Some ETNs also throw in fees for hedging against currency fluctuations, and these fees can change on a daily basis.

You’ll find yet other products that don’t charge any fees at all, and these miracles of financial engineering presumably cash in with juicy bid-offer spreads where the issuer is the only market maker.

You’ll also pay a commission to trade via your broker and it’s worth taking a good look at the ETN’s tax status too.

Though ETN’s are debt instruments many seem to be liable for capital gains tax rather than income tax. The tax law still seems to be solidifying on this one, so I wouldn’t take anything for granted. You can also render the whole worry moot, but dropping them into an ISA or SIPP.

On the upside, with ETNs you won’t get stung for stamp duty nor should tracking error be a problem, as the issuer promises to pay the value of the index (less any fees, of course).

Why use ETNs?

ETNs are meant to be a low cost route to portfolio diversification.

For example, if you plumped for the RBS Emerging Market Tracker (annual fee = 0) then you can gain exposure to the world’s hottest economies far more cheaply than through an ETF or index fund.

But I’m not tempted for a number of reasons:

• The heightened counter-party risk is not to be sneezed at. While it’s easy to think of the investment banks as impregnable fortresses buttressed by government backing, the deteriorating situation in Greece is a timely reminder that global financial markets are far from stable.

• Less apocalyptic, but adding to my sense of unease, the general standards of transparency relating to ETN documentation and websites are poor. I’m not going to invest in something that feels shrouded in mystery.

• There are countless variations on the theme. Watch out for leveraged versions, discounted trackers that keep the dividends in exchange for a cut-rate starting price, barrier levels and bonus levels… rampant innovation causes investing accidents.

• More than anything, the principles of passive investing rely on accepting the return of a diversified portfolio that invests in broad market indices. By contrast, most ETNs focus on thin wedges of the investing pie that expose investors to risks there’s no real need to take.

Take it steady,

The Accumulator

 

Good reading from around the Web.

It’s taken over two years and more financial plot twists than you’d get in an episode of EastEnders: Canary Wharf edition, but I’m finally nervous about one of the economic dramas that so excites the world’s worrywarts.

I’m not too bothered about Europe. Despite claims such as those made by The Economist in my reading list below that the situation in Italy and Spain is the real threat, I have long shrugged my shoulders at the escalating crisis and uttered a Gallic “boff!”

Nobody should be surprised by what’s come to pass so far in Europe – it’s the inevitable result of monetary union without fiscal and political union – and Europe as a whole can meet its obligations. But doing so will entail the deeper integration long hankered for by Europe’s politicians but not its people, ushered in through the bond market’s back door. Sixty-odd years after the EU was set-up partly to contain its nationalistic ambitions, Germany will finally be at the heart of an integrated Europe. Whether she’ll be pleased is a different bowl of sauerkraut.

No, much more worrying is the complacency in the market about the threat of a systemic shock of some sort due to the farce unfolding in Washington.

Newspaper headlines are desperately trying to conjure up a ‘market in meltdown’ on these fears, but in fact, the markets haven’t moved much. In the epicenter of the potential quake, US government bond yields have actually dropped, meaning purchasers are judging them safer, not riskier – even as the chance of a downgrade to AA status or worse grows.

I can’t believe the US would be so insane as to default on its debts, but if it does then it will be tin hat time with nobs on.

Quoted by CNBC, Credit Suisse analyst Andrew Garthwaite finds that if no budget deal is struck but the U.S. does not default, each month of no rise in the debt ceiling could easily take 0.5-1 percent off GDP. He predicts equity markets would drop by 10-15%, prompting Congress to find a solution, and that bond yields would fall to 2.75%. Investors would in Garthwaite’s opinion need to get into defensive stocks, and out of the dollar.

But far worse would be an outright default:

That is where things could get nasty, according to the Credit Suisse team.

“This is very unlikely, but if it occurs, GDP could fall 5 percent plus, and equities by 30 percent,” Garthwaite said.

I think even this understates the dangers.

My concern is that the vast issuance of financial undertakings known as repos (repurchase agreements) that make the money markets go around are explicitly linked to the so-called risk-free rate, which is invariably AAA US government debt. A minor downgrade or default that might seem amusing to Republican revisionists could unwittingly set-off a massive chain reaction if it threatens the small print of these multi-trillion dollar obligations – a fear that is already causing some in the City to sit on their hands in a disturbing echo of the post-Lehman’s lock-up of 2008.

Hopefully there will be no US downgrade, and if there is then hopefully such small print will prove a technical sideshow.

However it’s the unforeseen dangers and the unintended consequences that tend to spark true financial routs.

[continue reading…]