JR Snell Capital Management, LLC

A couple of words about bonds here… and a little bit of a warning as the media-hype machine touts the past success of bonds.

(Hint: Although the monkey thought it was all in good sport, we all know what happened to the weasel next.)

My long-running pseudo-battle with Bill Gross and the Bond Sellers came to an end this fall when we exited our long-term Treasury positions. I still do not like long-term bonds as an investment vehicle right now. The simple reason is that the price is too high.

The price of the long bond (20+ year Treasury) ETF (TLT) is being held up at weirdly astronomical levels by investors who can’t think of any safer place to put their money. The troubles in Europe have driven investors around the globe out of the Euro and European country’s sovereign debt and into the dollar and US debt.

Remember this: People are not buying US debt because it’s “all that”… it’s not, and it’s providing a lousy rate of return… but, hey… we can print our own money and the Europeans can’t, so Treasuries seem to make a pretty decent “mattress” for global investors to stuff their cash into at the moment.

I have my ears to the track and I’m hearing that money has been coming out of stock mutual funds at another record pace here recently. And where is that money going?

U.S. stock mutual funds that invest in domestic equities had their second-biggest redemptions last year as record market swings sent investors to the perceived safety of bond funds.

And why do we suppose it’s going in to bond funds?

Despite a reputation for being a slow-growing alternative to stocks for the risk-averse, bonds just passed stocks’ long-term performance over the past 30 years.

Many investors chase last year’s winners, perennially dooming them to under-performance… not to mention it makes you feel like you’re always in the wrong place at the wrong time… very hard on the ego. It’s kind of like charging into real estate in 2006: It seemed like a good idea at the time.

In fact, you are actually witnessing an historical event: A bond bubble that offers the most expensive bond market in your lifetime. Don’t bite… The minute Europe straightens out their situation, the bond market bubble will pop.

Here is a very wise investment technique (good for all fields at all times): Take the time to figure out precisely what everybody else is doing… and then do the opposite.

ACTION ITEM: If you have bond investments, reduce or eliminate your allocation to them.

Bill Gross, Bond fund, Bond market, Exchange-traded fund, interest rates, investing strategies, Investor, Mutual fund, treasuries, treasury, United States, United States public debt, United States Treasury security, William H. Gross

Technically, a “perfect” hedge is to have in your portfolio two assets that act exactly opposite each other at all times. A bit like buying 100 shares of AAPL and at the same time shorting 100 shares of AAPL. For every dollar that you make on the 100 shares that you own, you lose a dollar on the 100 shares that you are short… a perfect hedge; no matter what AAPL stock does, the value of your investment will always be the same, in theory. In reality, the transaction costs and the margin costs for the short stock will ruin your otherwise perfect hedge, so no one would even attempt a position such as this. Or would they?

One of the basic principles of Asset Allocation Theory is that certain asset classes are inversely correlated (act opposite of each other) and therefore by owning each of these asset

The Only Truly Perfect Hedge

classes, you lower your overall risk. If the stock market goes up by the same percentage that a certain bond fund goes down, they are said to have a correlation of -1.0, which means they move 100% opposite of each other. Correlations between investments can run the gamut from +1.00 to -1.00, meaning that they can both move together perfectly or opposite each other perfectly. Two growth stocks like GOOG and AAPL might have a correlation close to +1.00, which means when one goes up the other does too. And vice-versa.

Let’s imagine that it has been recommended to Conservative Mr. Jones that he put 60 percent of his money in the bond market and 40% of his money in the stock market. One study shows that a typical bond market investment has a correlation of -.68 to a typical stock market investment. If the stock market rises by 20%, then Mr. Jones’ stock investment will increase his whole portfolio value by 8% (40% of 20%) and the bond value will decrease his portfolio by 8.2% (60% of 20% * -.68). Isn’t this about the same as doing nothing? Throw in transaction costs and it’s worse than doing nothing.

Most investors that I’ve worked with, when they think about how they want to invest, feel like they want to participate in the stock market’s long term opportunity, but they want to temper their risk a bit if things get “dicey”. Let’s say you’ve been considering allocating 70% of your money to the stock market and 30% of your money to the bond market, why wouldn’t you just subtract out the negative correlation percentage that the bonds will provide (30% * -.68 = -20.4%) and put about half of your portfolio in stocks (70% – 20.4% = 49.6%) and sit on the rest in cash for some future opportunity? (Like Roulette)

So when things do get “dicey” like they’ve been recently, we don’t end up saying silly things like, “Hey, at least you made a little bit of money on the bond side”, which is a bit like, “Apart from that Mrs. Lincoln, how did you enjoy the play?”

Instead, we’ve got a little bit of our “perfect hedge” laying around in cash to bring our stock allocations back up to whatever target level we’re trying to maintain.

This is also known as buying low.

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OK, I’ll shut up now. I’m taking my ball and going home.

If you’ve been reading my comments for any more than a month, you’ll see that I can’t shut up about Treasuries… “They’re a good investment, that you need to own them, that they look like a good trade, that the biggest bond buyer in the world hates them… and then he was wrong.“ Starting with this post in February of this year (2011) where I laid out my original rationale for owning longer treasuries through the exchange traded fund, the TLT.

…and now I’m gone. Done. Sold them all. Why? Because everyone wants to own them now. There’s a bit of stock market panic in the street and everyone’s rushing toward treasury bonds.

Here’s a chart along with my narrative. You can plainly see that something is “out of whack” on the right hand side of the chart:

The last time I personally observed panic demand for these bonds was during December of 2008 and we happened to own a bunch of them back then too…. and I was more than happy to sell them out of client accounts back then too.

A couple of days ago I wrote an article about how we reserve part of a portfolio for bonds and a part for stocks, and we move in and out of the asset classes as appropriate. You can probably guess that most (if not all) of the bond portion of our accounts have been filled out with TLT since February.

Now, the tactical bond portion is empty again… as you probably figured out.

Here’s where it gets interesting… We’ve been unloading stocks out of client accounts since my May 2011 post called, “Time to Start Digging?”. As I write this post, we’re left with only about 6% to 8% of our capital in stocks because of it.

For clients, this means that for the last couple of months and doubly the last week or so, we’ve made more on the bond side than we gave up on the stock side… which is exactly what I tried to explain what I was shooting for a couple of days ago.

Of course, the tactical cupboard is bare. We’re out of stocks and out of bonds. And you know what? Given all the goofiness in the world at the moment, I can’t imagine a better place to be right now. Not to mention I’ll finally shut up about those damn bonds!

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