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The asymmetry of the bond market

November 17, 2023

The President of the United States gave a speech about fiduciaries and annuities, and it was pretty good! Fiduciaries = good, annuities = bad. Well he actually qualified his statement on annuities, probably because lots of people in that industry donate to his campaigns, but it was still a big warning coming from the president.

"Fiduciary" is an odd-sounding term that has gotten traction in the public lexicon. This is a major problem to our competitors, as for decades they have been able to wash their conflicted advice away with sweet-sounding words. Now what is happening is people are walking in and saying "Are you a fiduciary?" And they say "By the way I meant to ask you how your grandkids are doing?" And the client says, "They're absolutely wonderful, but I said 'Are you a fiduciary?'" At which point it is definitely time to distract the client and start talking about lithium shortages in electric battery production.

Here is the new little trick emerging from financial firms, and you should be aware of it. Make one account a fiduciary account, and the others continue with the usual profitable shenanigans of being paid product commissions. So if you ask a firm the question, make sure you ask "Are you a fiduciary on all accounts, all the time." Learn more here.

Note that being a fiduciary is good, and it rises above the ethical swamp no one should be in anyway, but it doesn't necessarily make someone a good investor.

Remember, the industry doesn't get fixed until people move their assets away from those firms. It's certainly not going to fix itself. It's up to you how you want your future to be.

Now to the bond market. There is so much interest in the bond market these days! I think this is a reaction to increased interest in the Federal Reserve. Chairman Jerome Powell does not light the room on fire, and probably shouldn't, but at least it appears to Americans that the Federal Reserve functions. And so it's kind of fun and comforting to think part of Washington works, and so people watch it more.

Remember that the bond positions in your portfolios are there to offset the equity market. They are the rebar to concrete, the yin to the yang. Ultimately, when something goes very bad in the stock market, they are your life raft.

The interest rates we are at now are close to the long-term normal. They are not "high" as the media reports almost daily. Here is James Grant, the founder of Grant's Interest Rate Observer:

“Five percent is more or less the average of investment-grade rates since the time of Alexander Hamilton. The problem is the structures that 10 years of ultra-easy money brought about. People blame it on the normalization of rates. The previous bout of abnormal rates is the problem.”

In our view it's good to get back to normal. Paying interest to borrow money is a fundamental tenet of capitalism, and it's good to get back to it. It helps avoid asset bubbles and asset allocation errors (like junk companies that shouldn't exist).

We don't know what direction interest rates will go from here, but most bonds have asymmetric forward-looking returns now, particularly in longer durations. For example, if interest rates rose 1% from here, in a long-duration Treasury bond fund such as TLT you would lose 10.8% over the next year. But if rates go down 1% from here, in the same fund you would gain 22.3%. This is a function of what is called "convexity" in bonds, and while that term is not as well-known as "fiduciary," convexity currently means that your gain or loss on the same interest rate movement, but in different directions, is asymmetric. We did a little graph of TLT so you can see more data points visually. Click to see it here.

Dan Cunningham

1. Bond data above as of 10/27/23.

The divergence of short-term and long-term perspectives

October 13, 2023

By this point in 2023 you may have noticed that both the stock and bond markets seem decoupled from the news. You hear good economic news, and the bond market goes down. Sometimes the stock market goes up, sometimes it goes down. A war starts and the stock and bond markets rise. If you're confused, and wondering if it's you, it's not.

The amount of debt and leverage in the U.S. and around the world, has increased steadily over the past twenty years. Reliance on debt has made the Fed a larger player in the economy, to the point that high schoolers know the name of the Fed chairman. The economy may say one thing, but its implications on future Fed actions may argue the opposite. And markets have to choose their dominant signal on a given day.

To make matters more difficult, historical macroeconomic models are not working well.

I need to correct one common misconception. People assume they are making 4% - 5.5% in bank savings accounts, CDs, and short-term Treasury bills. With rare exception, where these are held in retirement accounts, they are not. This interest is taxable and the after-tax rate they are making is in the 2.5% to 3.5% range. This is a more accurate return number.

They feel good in these products, but they shouldn't. They have opted for a terrible investment medium to long term, one that even in the short term, due to its tax inefficiency, is producing negative real returns. While we can't know the future, I expect there will be a lot of regret and market-chasing five years from now as people try to reverse this strategy at just the wrong time.

Outside a small group of investing nerds, almost no one has heard of Seth Klarman, a Boston-based hedge fund manager and arguably one of the best investors of all time. He likes it that way. Fourteen years ago I managed to get my hands, or eyes, on a PDF of a book he wrote, Margin of Safety. This book currently sells for $3,780 on Amazon, given that Klarman doesn't want it back in print.

Klarman is a value investor who focuses on buying things on the cheap. He is one of few professional investors who reportedly does not use a Bloombeg terminal, as he does not care about short-term price fluctuations.

In his book, he says:

Consider the example of a five-year 10 percent bond paying interest semiannually which is purchased at par ($100). Assuming that interest rates remain unchanged over the life of the bond, interest coupons can also be invested at 10 percent, resulting in an annual rate of return of 10 percent for that bond. If immediately after the bond is purchased, interest rates decline to 5 percent, the bond will initially rise to $121.88 from $100. The bond rises in price to reflect the present value of 10 percent interest coupons discounted at a 5 percent interest rate over five years. The bond could be sold for a profit of nearly 22 percent. However, if the investor decides to hold the bond to maturity, the annualized return will be only 9.10 percent. This is less than in the flat interest case because the interest coupons are reinvested at 5 percent, not 10 percent. Despite the potential short-term profit from a decline in interest rates, the return to the investor who holds on to the bonds is actually reduced.

Similarly, if interest rates rise to 15 percent immediately after purchase, the investor is faced with a market decline from par to $82.84, a 17 percent loss. The total return, if he holds the bond for 5 years, is increased, however, to 10.99 percent as coupons are reinvested at 15 percent.

Notice that the short-term and long-term perspectives here are quite different. Assuming no default or pre-payment risk, the investor knows the bond is going to pay back its value, at par. And in the meantime, it's better for the bond to decline so the investor can buy more. But it doesn't feel that way in the short term.

While markets don't have guaranteed payback endpoints, this is a powerful idea. We believe it becomes even more powerful as it is implemented across asset classes.

Dan Cunningham

Is dominance of big tech in the S&P 500 a problem?

September 15, 2023


1. We are now going into businesses for lunch and offering seminars, trying to teach people what is going on in the financial industry. Some of us here call these Lunch & Learns. Those less enamored with alliteration call them Employee Wellness Seminars. In any case, if you work for a business and would like to explore this, contact us at 802-503-8280 and ask for Burta.

2. We were named the 29th fastest-growing registered investment advisory firm in the United States by SmartAsset this week. A lot of you have helped with this with introductions and referrals, so you should consider this page yours as well. We thank you.

3. Finally, our Hanover, NH office is now open on South Main St. Contact Nancy Westbrook if you are in that area and interested in meeting: 802-341-0188. Or see the Hanover office web page.

I am seeing a lot of discussion regarding the concentration of big tech firms in the S&P 500, and whether or not that is an undue risk. This summer, the top seven tech firms made up 28% of the value. You can see a visualization here.

The concentration certainly has negative and positive effects on the business environment. You can throw societal effects into that mix as well. But the hand-wringing over the negative effects on the index is likely overdone, particularly in relation to your other options.

Burton Malkiel, a Princeton professor and a founder of the indexing movement, wrote this piece in the WSJ this week. It's very good, I suggest reading it this weekend.

Malkiel highlights the history of this "narrow market" argument, using the dot-com era as a backdrop. The worry around concentration was evident then. In hindsight, it was misplaced concern, as the S&P outperformed active managers over the twenty year period ending in 2009, a time frame that ended in the doldrums.

This thought from the article is important: The basic idea of efficient markets isn’t that prices are always correct. In fact, they are always wrong. What efficiency implies is that information is reflected in prices without delay.

The reason the market "is always wrong" is that everyone has their own methodology to corporate valuation. So if you and I value, say, Crocs, we're probably going to come up with different results. And the market value of Crocs is not going to reflect either of our conclusions, because the market is factoring in thousands, if not millions, of other opinions. It's interesting that something that "is always wrong" can outperform almost everyone over time. What a paradox.

Finally, note this paragraph: There is no way to predict which active managers will be the best stock pickers. Portfolio-manager fees are the only reliable predictor of performance. The lower the fees, the higher the returns realized by investors.

Dan Cunningham

1. Firms were ranked based on changes in client account totals and assets under management (AUM) between 2020 and 2023. Firms were only considered if they had at least $500 million in AUM, had no regulatory disclosures related to disciplinary action, and offered financial planning services. SmartAsset released the list on 9/6/2023.

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