Welcome to the Amusement Park
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Despite a large group of popular websites and magazines that suggest investing is becoming ever easier, I believe things may actually be getting more difficult. The act of buying or selling a security has certainly been simplified through toll-free numbers and internet access but coping with the forces which drive markets has become harder as more investors take part. In explaining some of this to a client recently, I found myself comparing various market activities to amusement park rides, an approach I’m going to expand upon over the next few weeks. I’m concerned about the bond market right now so we’ll begin our visit with the teeter-totter. It is, of course, a device that depends on balance: when one side rises, the other falls. This also describes one of the most basic aspects of the bond market: the correlation between bond prices and bond yields. Suppose for a moment that you have a Carter-era CD in your pocket and it’s paying a (then typical) rate of 15%. Assuming that there’s a market where CDs can be easily traded, do you imagine you’d have any trouble selling it? Current rates are about 3%, so that market would tend to adjust the price of your bond so that you’d receive about five dollars for each dollar you invested, giving the buyer today’s 3% return. Of course, if you had a CD issued last year at 1.5%, you could sell it too but probably at something closer to fifty cents per dollar, also providing the new investor with a 3% return. Unfortunately, this relationship between bond interest rates and prices is not very widely understood. The bond market suffered a significant decline in 2008 as news of problems with mortgage-backed securities hit the front pages but, in spite of the headlines, markets rarely go all the way to zero. This offers investors a chance to make money during a cyclical rebound. That being the case, it should not be surprising that 2009 was a good year for bonds. While interest rates are up a bit compared to 2008, they are still quite low from a historical perspective. With rates near their generational lows, I suspect they are more likely to go up than further down. As you’ll remember from the teeter-totter illustration, when interest rates rise, bond values fall. Those who prefer a simpler approach to investing in bonds can do so via bond mutual funds. A mutual fund can be thought of as a group of people investing together in a pool of securities. While easier than choosing individual bonds, bond funds present their own difficulties. Because of the bond market recovery, bond funds provided some of last year’s highest returns, a fact trumpeted in their ads. Unfortunately, many average investors don’t really understand the ins and outs of market movements. They see the ads and tend to buy those funds which have done well recently. History has shown that one year’s best performing fund rarely delivers great performance again the next year. This tendency of investors to buy the wrong funds at the wrong time brings us to the underlying problem with bond mutual funds. Each investor is basically at the mercy of the least experienced of their co-investors. How? Well, those investors who bought the fund because it had a good year in 2009 are certainly hoping for good performance going forward. But we already know that rising rates will lead to falling values. During previous market cycles, we have watched as the least sophisticated investors decided to sell their shares as they saw values falling. When mutual fund shares are sold, the fund managers must sell individual bonds in order to send cash to the sellers. Selling bonds into a falling market means that all remaining owners will suffer a loss, even if they don’t sell their own shares. I doubt if you’ll find the “teeter-totter effect” mentioned in your old college economics textbook but regardless of how it is described, the price/yield relationship certainly exists. Once such a connection has been identified, it’s the role of an advisor to develop an approach to deal with it. Warren Ward Associates is always searching for the best possible strategies to answer financial questions as they arise. As you might suspect, we do have suggestions for investing in today’s bond markets. We’ll take a look at other amusement park attractions in the coming weeks, including the roller coaster, the house of mirrors and perhaps even the terrifying drop tower. In the meantime, please give us a call with any questions. |
Don’t Let That Bully Shove You Around
I suppose a case could be made that I spent too much time and money on comic books as a youngster. In their defense, however, reading them provided me with multiple opportunities to learn about how a skinny kid on the beach could develop a muscular body and win back the girl from the bully who once kicked sand in his face. Recent news about the Greek bond situation has brought the idea of bullying back to mind. For the past several months, we have heard about problems with sovereign debt issued by the government of Greece, a topic I addressed in the article Beware of Greeks Bearing…. A plan to offer some sort of guarantee of Greece’s debt is moving forward, although not especially smoothly, as their Euro zone neighbors try to decide what an appropriate level of assistance might be. Problems with government finances are nothing new; over the years many countries have gotten themselves into financial trouble. Because of that, Greece has another potential source of financial support in the International Monetary Fund (IMF). The IMF was established towards the end of the Second World War at the Bretton Woods Conference. Since then the it has provided financial assistance numerous time but always with strings attached. Their policy is to provide aid only if the country is willing to deal with the issues which the IMF believes underlie the financial problems. For example, following Nicaragua’s Contra/Sandinista conflict in the 1980′s, money was provided to rebuild infrastructure but only on the condition that the government adopt policies more friendly to foreign investors. In the late ’90′s, the IMF moved to help several countries in Asia, offering aid if certain structural adjustments were made. These included cutting government spending to reduce deficits, allowing insolvent banks to fail and increasing interest rates in hopes of containing inflation. I must admit to watching these actions with a certain amount of satisfaction. Since these countries were obviously not well-governed, it seemed appropriate that they should be forced to “get their acts together” if they wanted help.
Since the IMF’s description of Asia’s problems sounds uncomfortably familiar, I’ve recently found myself wondering how it might feel to be one of those receiving aid. In addition to their other activities, the nice folks at the CIA compile a yearly almanac called the World Factbook and I spent a little time going through it recently. It should come as no surprise that our complex global economy is made up of a group of national economies encompassing a wide range of economic conditions. While we are used to assuming that the United States is generally in pretty good shape and that our economy is among the most important in the world, there are a number of countries who are better off. In terms of total economic output per person (GDP per capita), Liechtenstein barely edges out Qatar, each having an output greater than $120,000 per person. The USA has dropped out of the top 10, currently sitting at number eleven with an output of $46,000 per person. As far as unemployment, Monaco reports none, with Qatar in second with ½%. The USA lags Cuba, Botswana and Portugal with a 9.4% rate, putting us 109th. In growth of industrial production, the developing countries of Gambia and Congo are first and second with the USA finishing 110th. We are world leaders in one significant category, however, that of debt payable to people and countries outside of our borders. The IMF requirements placed on those Asian countries in the late ’90′s should sound pretty familiar to most of those reading this article. The economic meltdown of 2008 forced several changes in our system, although all were leavened by political considerations. As we ponder the likely strikes in Greece in protest of various cutbacks, we might want to reflect on choices made, or not made, by our own government. The adage about chickens coming home to roost has been floating through my mind as I ponder how it might feel for Germany, or Liechtenstein for that matter, to dictate financial reforms to us before deciding to do business with us. Fiscal responsibility is absolutely necessary for a country’s economic growth but I suspect that any government would be better served to initiate reforms itself instead of having them enforced from outside its borders.
