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

7 thoughts on “Nine Business Days Ago

  1. I’ve trimmed some ESV and RIG into this upward move. It kind of made feel ill so I think this is a good decision on the gut basis as these offshore plays have really worked. I also have positions in HAL, NBR, and GW but I believe all of these have a 10% plus move in them before I need to sell more. Rebalancing is so much more fun when it is done on a PROFITS basis.

  2. I have higher friction costs and haven’t sold anything yet in my trading account. But I have been devoting a lot of thought to what I should sell among positions that have increased lately. My short list is SBS, APC, OXY, DVN, XEC, DO, JRCC, CCJ, CQB, DK, NTO, PNR, KBR, and NADX.

    With the exception of SBS, CQB, PNR, and NADX they’re all commodity and overwhelmingly energy-related. To borrow from Cody Willard, I wonder if I shouldn’t “flip it” and increase my exposure there instead.

    I look forward to the RM article and the portfolio reshaping.

  3. Paul, we have positions in many of the same areas, but no overlapping names here. Good going on the trimming, and I agree, it is always easier going up, but what portfolio management method isn’t easier in a rising market?

    That said, it was the reshaping and rebalancing in 2002 that allowed me to have my best year ever in 2003. It was painful at the time, but it really paid off. I hope I never have to write this article, but I have one more rebalancing rule for what to do when you run out of cash. I had to use that rule two or three times in 2002, but it helped going into 2003.

    amccabe — I would sell a little, but that’s just my risk averse nature.? Cody would smile (or blanch) at your “flip it” being applied that way (now we both owe him a nickel — I’ll cover you the next time I buy him a beer), but the amazing thing about trends in the market is that they persist far longer than most expect.? Not only does the market climb a wall of worry, so do internal market trends.

    I still rebalance, even when I like a trend.? I usually make it up in short term sell-offs.

  4. Rebalancing the financial names has been no fun as almost all were hammered; as you know I didn’t do it nearly enough and paid the price. The strong balance sheet rule is a BIG one to pay attention to; the hard part for almost all is as cash builds up it is difficult to not allocate to a “good idea” as most of the time you don’t get too punished for it.

  5. I ended up taking some energy profits this afternoon. It was tough, but I fell relieved. Because I’m not a pro, and have less certainty in my analysis of individual companies, I’ll often spread an investment on a trend across several companies. As a result, it won’t always be feasible to sell half of a position without transaction costs being too high. And for whatever reason, the mental hurdle of selling all or nothing is a little more difficult to get over than scaling out more gradually (even if it amounts to the same thing in the context of my investment in the trend overall).

    Anyway, thank you for the push in the smart direction (and covering my CW royalty payment).

  6. graywilliams — I made a passing reference to what is dear in my life, Jesus. Nothing big in content terms; I internally debate how much to put forth that I am a Christian as I write here. Most people who work with me slowly find that out; I’m a gentleman, and most people are leery of people who are too forward with their beliefs. My style derives a lot from what I believe, which teaches me to be humble, cautious, and control risks. (I fail at all of those sometimes. 😉 ) When I was a bond trader, maintaining a high level of ethics paid off for my clients, because so much of what you do is based on trust. I treated my brokers as I would have wanted to be treated myself, and oddly, I got loyalty from them.

    On the sovereign funds, I am short-term bullish, and long-term bearish. It’s always dangerous to have players in any market that might not be valuation-sensitive. Those that manage sovereign funds face the difficulty of deploying a lot of funds in a structured way; usually investors with a flood of funds to invest become less cautious than they should be. As an example, let me trot out the Equitable from the 1980s. They mispriced the Guaranteed Investment Contracts that they offered, and drew in a flood of cash seeking the high yields. The investment department could not handle the flow. (No criticism implied. I mean, who could? I went through a lesser version of this back in 2001-2003, managing assets from the fastest growing insurance company in the US. It was tough.) The liability error led to errors in investing the assets. This is another reason to be careful of financial companies that grow too quickly; when the assets grow too quickly, errors get made.

    Thanks for commenting.

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