You are what you eat?

The graph above says it all. It compares the yield spread between a Procter & Gamble corporate bond maturing in 2012 to a comparable treasury bond (same coupon and similar maturity). A positive spread occurs when the yield to maturity of the corporate bond is more than that of the treasury (which is as it should be). Lately, a certain number of corporate bonds have been priced with yields that are inferior to that of treasuries. This is an interesting situation because it means that investors perceive treasuries (backed by the full faith and power of the U.S. government) as being riskier than that of a corporate bond. Mind you, there are many businesses out there that have very clean balance sheets (at least cleaner than that of the Fed) and for some of them (we all know who they are), it is partially thanks to government intervention that they are in better shape.

The perception of risk is clearly shifting for government debt mainly because it has a large (and growing) inventory of the riskier kind of debt that is starting to take over a larger portion of their balance sheet. As the saying goes, you are what you eat!

Asset allocation insights...

We all know that the risk profile of a person changes with time. As a result, the tradeoff in allocation between riskier (equities) and less riskier (high investment grade bonds) assets should also change through time. Riskier assets are basically required so that the portfolio can grow in real terms (faster than inflation) but, over the short term, can prove volatile. Riskless or low risk assets, on the other hand, tend to exhibit far less volatility (much appreciated in down markets) but won't provide you much in terms of growth.

At a younger age, a more "dynamic" risk profile, defined as a portfolio with a larger allocation to "riskier" assets such as equities, is more appropriate mainly because the person in question typically has a job, which provides a steady stream of income into the future. In other words, the human capital in terms of income generation is much larger for a young person. As the person approaches retirement age, however, this steady stream of income is expected to expire as the human capital potential continues to decay steadily. Human capital is similar to a "bullet" type bond in the sense that a steady income is generated until "maturity". If we are to optimize portfolio, we need to adjust it for the human capital potential. Thus, at a young age, the portfolio allocation to equities should be significant, as the income is assured by the human capital. As the person approaches retirement, however, the human capital can no longer assure a steady stream of income and, hence, a larger allocation to fixed income becomes necessary.
It goes without saying that the shift from one risk profile to another should not be abrupt but progressive.

We can take this thought one step further and think of human capital containing an "embedded option" in the form of the individual's ability to change jobs (with potential repercussions on future income streams). Just like the human capital itself, however, the "embedded option" is subject to time decay. As we get older, our ability to change jobs diminishes. This would imply that as we shift to a more conservative risk profile, in addition to a larger allocation to fixed income, we may need to somehow account for the gradual loss of the "embedded option".

A lurking danger...

Bond yields have been steadily rising ever since the stock markets began rallying, right about a year ago. The reversal in trend was a reflection of the growing appetite for risk, following the market turmoil of 2008. The long end of the curve may also reflect anticipation of both inflationary pressure over the longer run and the gradual withdrawal of government support (such as quantitative easing) for the economy.

The problem with rising yields is that maturities on the yield curve are typically used as reference benchmarks to set interest rates for various industries. The mortgage market, for examples, typically looks at the 10 year segment of the curve to set the interest rates that will be charged to the home buyer. With recent economic releases suggesting weakness in housing, employment and consumption, a rise in the yield curve is likely to have an asphyxiating effect on the health and recovery of the economy.

How to interpret the Fed's latest move...

The Fed caught everyone by surprise with their decision to hike the discount rate by 25 basis points right after the U.S. market close last night. Markets reacted negatively, whilst the dollar continued to strengthen.

As a reminder, the discount rate is the rate that the Fed charges banks that want to borrow directly from it. When the crisis began in 2007, the Fed embarked on an aggressive rate cutting process. The discount rate eventually settled at an unusually low 0.5% towards the end of 2008, whilst the target rate (a main tool for setting monetary policy), which is the rate the Fed sets for inter-bank federal funds lending, dropped to a low of 0.25% around the same time. At the time, there was no sense in cutting rates any further as a so called liquidity trap had formed, whereby the stimulus effect of cutting rates any further had effectively become null.

So what is the message behind the move? My interpretation would be that this change marks the beginning of the end of the emergency support to the financial system. I doubt very much that tightening of the target rate will come any time soon. There is still a lot of damage out there and the economy is still a long way away from being able to walk about without government crutches. This move effectively paves the way for additional withdrawals of support. I expect quantitative easing to be one of the next major candidates on the list.

The burden of uncertainty

It is a well known fact that one of humankinds greatest burdens has to do with uncertainty, and just like its distant cousin, infinity, our minds have a difficult time coping with the concept. Countless studies have shown, for example, that we are much happier once something that was uncertain becomes certain, even if it happens to be something unpleasant. Apparently the mere presence of certainty removes a whole layer of tension.
Markets behave in a very similar manner and the degree of uncertainty can easily be measured by the degree of volatility. It is why in times of serious trouble, as in the second half of 2008, volatility levels can rise dramatically.
As uncertainty is perceived to be an unpleasant experience, it acts as a powerful driver that pushes us to come up with solutions to counter it. The insurance business is a perfect example of an industry that has flourished as a direct result of mankind's desire to counter uncertainty. Corporate earnings announcements is another example whereby the time frame between earnings reports have been shortened in order to reduce the degree of uncertainty regarding the health of a business. Such strategies do come at a price, however. By increasing the frequency of earnings results in a given year, the firm may be sacrificing long term objectives for short term gains.
With all this in mind, the EU's willingness to bail out Greece and Abu Dhabi's intervention on Dubai should come as no surprise. In both cases it would seem that the uncertainty of doing nothing is just too large of a burden to cope with.

A fluke or for real?

Last week's announcement that the U.S. economy had expanded in the fourth quarter (the second consecutive expansion) by a greater amount than what the market consensus expected took everyone by surprise, raising the risk that the resulting complacency may lead to a premature withdrawal of some of the more critical stimulus plans in place.

The trouble stems from the nature of the downturn which in this case is structural rather than cyclical. Historically speaking, it takes an economy significantly longer to recover from a structural downturn than a cyclical one. The combination of greater government regulation in an environment of high unemployment and weak consumption can only contribute to extending the period of slump. The stock market rally in 2009 may reflect a disconnect between expectations and the real fundamentals and, as a consequence, stocks may disappoint this year.

The tough road ahead...

According to Ibbotson Associates, a well respected data mining firm, since 1926, U.S. stocks have returned on average 9.8% per annum. This is the compounded annualized total return (i.e. including dividends that are reinvested) of the S&P 500. Over the same period, bonds, which is the other major asset class has returned 5.3%, significantly less than equities. Taking the more recent past such as the last 10 years, however, the results are -2.22% and +6% for equities and bonds respectively, in stark contrast to the longer term where the equity investor was the clear winner. These results tell us that although we can expect average returns in the order of 9.8% over the very long term, we can experience significantly long periods (a decade in this example) where average returns could turn out to be substantially below this figure.
This example illustrates well the importance of diversification amongst asset classes because although even for a diversified portfolio, correlation aberrations over shorter term periods such as in 2008 can lead to significant losses, over the longer term they are likely to be diluted somewhat.
Coming back to the 9.8% return expectations drawn from data that spans over a very long period, it is not very realistic to expect such returns into the future, particularly in an environment of weak consumption, investment and greater fiscal discipline. To make matters worse, the Ibbotson figures happen to be gross of inflation (average 3%), investment expenses (average 1-2%) and taxes (average 1-2%) which means that if we were to calculate the net expected annualized total return for equities, it would add up to between 2.8% (worst case) and 4.8% (best case). You may argue that inflation is a non issue because we haven't seen much of it over the past decade, but the future may turn out to be very different given the quantity of stimulus out there. In any case what is clear from the above is that to be able to generate a decent return over coming year is going to require a lot of skill that only true professionals can provide.

A mirror image of a year earlier?

2009 turned out to be a year in which most asset classes yielded positive returns after a rough beginning. Just about the only asset class that performed negatively were treasury securities (the only asset class that yielded positive returns a year earlier).
Just as in 2008, correlations were generally relatively high but because the move was in the opposite direction there wasn’t much to complain about (unlike in 2008 when pundits were suggesting that diversification was dead). Commodities recorded the largest gains, followed closely by equities and real estate and finally hedge funds that rose steadily throughout the year. A recent measure of home price to rent suggests that problematic markets such as that of the U.S. are now close to their historical fair market value (could that really be?). The same measure also indicates that certain European countries such as Spain, U.K. and France and bubbly places like Hong Kong are substantially overvalued which means that we can expect the slide to continue in those markets.