Nine Business Days Ago

The most recent closing high in the S&P 500 was on June 4th.  Since then, we have been through a spin cycle where all that mattered were yields on the long end of the Treasury curve.  That’s why I wrote late on Thursday at the RM Columnist Conversation:

David Merkel
Bonds and Stocks Decoupling? They were only Together by Accident.
6/14/2007 4:50 PM EDT

I was somewhat skeptical when I saw bonds and stocks trading in tandem. The relationship between bond and stock earnings yields is a tenuous one operating over the long haul and on average. Using the five-year Treasury as and the S&P 500 my proxies, bond yields have exceeded earnings yields by as much as 8% in the mid-’50s, while earnings yields have exceeded bond yields by more than 4% in 1981, 1984 and 1987. On average earnings yields are 32 basis points over bond yields. If there is mean reversion in the difference between the two yields, the effect is not a strong one. At present, the relationship between earnings and bond yields seems tighter because of the large substitution of debt for equity going on, but that’s not a normal thing in the long run.

Even with all the buybacks and LBOs, it isn’t normal for stocks and bonds to trade in a tight correlated way in the short run, so, take one of your eyes off of bonds, and look at the fundamentals of the companies that you own. You’ll make more money that way, and take less risk.

PS: if the ten-year crosses 5.50%, go ahead and look at bonds again, and maybe allocate some more money to fixed income. Repeat the process each 0.5% up, should we get there. Equilibrium for stocks and bonds on a valuation basis is a 6.50 10-year. We’re not there yet, so I expect the substitution of debt for equity to continue, albeit at a slower pace.

Sometimes I think investors and the media search for an easy target on which to pin their fears or hopes.  In this case, it was the bond market.  Don’t get me wrong, the bond market is important, and usually ignored by investors to their peril.  But using the bond market to make short term equity trading decisions is just plain silly.

Now, when actual volatility rises, my methods usually do well against the broad averages.  One of the things that I have tried to achieve in my adaptive approach to the markets is to create a system does does well in calm markets, but does relatively better in volatile markets.  Volatile markets scare inexperienced investors into making the wrong moves.  My methods are geared toward allowing ordinary investors to benefit from volatility in a rational way.  As I stated in the CC on Friday:

David Merkel
Rebalancing Trades
6/15/2007 11:55 AM EDT

Wow. Nice rally over the last chunk of time, and it’s time to “ring the register” and lighten on a few names that have run nicely. I do this primarily for risk control purposes. Here are the names that I trimmed: Noble Corp (NE), Cemex (CE), Lyondell Chemicals (LYO), and Tsakos Energy Navigation (TNP). They are now back at their target weights in my portfolio. My rebalancing discipline is a way of:

  1. Lowering risk on companies that are more expensive, and thus more risky than when I last bought them.
  2. Raising exposure on names that are cheaper, and thus less risky than when I last bought or sold them.
  3. Capturing swings in sentiment in industries, companies and the market as a whole, without becoming a momentum trader.
  4. Lowering my market impact costs by leaning against the wind (selling into a rise, buying into a fall), and
  5. Forcing a review process at certain price levels
  6. Taking the emotion out of selling and buying
  7. Making an additional 2% to 3% a year on my portfolio.

You can only do this with a high quality portfolio; don’t try this with companies that have a non-zero chance of a severe drop. For more information, review my “Smarter Seller” article series.

Position: long NE LYO TNP CX

Since 6/4, my broad market portfolio has outperformed the S&P 500 by roughly 1%.  My methods are designed to be able to cope with volatility and some back smiling.  Why can I go on business trips or vacation and not worry about the markets?  Why don’t I get scared by many of the negative macroeconomic situations out there?  First, I trust in Jesus; my life is not just the markets.  But beyond that, my eight rules are design to deal with the volatility that the market serves up, and adapt to what is undervalued in the present environment.

My plan for the next three weeks on the blog is to go through another portfolio reshaping.  You’ll get to see how I make choices in my portfolio.  Beyond that, I have one big article on the Fed Model coming, and continuing coverage of the major factors driving the markets.  Have a great weekend.

Full Disclosure: long CX TNP LYO NE