August 2, 2016
Bond ETFs, More Wall Street Snake Oil
The ability of individual investors to cost effectively buy individual bonds has been slipping away for the 30 years I have been in this business. Institutions now grab up whole issues of bonds before you or I can get a sniff of them, unless we are willing to pay for the privilege. Try selling a bond in your portfolio for the value on your statement and you’ll see what I mean.
Investors expect bonds to be as liquid as stocks, but they are not. Bonds can be very illiquid and can have trouble attracting buyers, causing sharp price drops from prices reported on statements.
The bond market is 9 or 10 times as large as the stock market. There are over 50,000 municipal issuers alone, and hundreds of thousands of different bonds. Small issues may not be closely followed by analysts, and when a seller comes forward it is possible that the few traders familiar enough with the issue to be interested have gone to lunch or home early for the weekend. At times like that, there are few or even no buyers and prices drop until a bargain hunter appears.
So, the bond market is very inefficient compared to stocks, and many bonds can be highly illiquid – difficult to sell without chopping the price.
Wall Street has a way of making the unreasonable seem right. Exchange Traded Funds, called ETFs, are portfolios with scores of different bonds so an investor can get instant diversification with one purchase. Bond ETFs are seeing huge inflows of investor money, because they are touted by Wall Street firms as being a liquid way to buy bonds. But I don’t believe they are.
ETF shares are created and redeemed when the spread between bond prices and the ETF drift apart enough to make the move profitable. ETF sponsors work with specialist firms that will buy or sell a block of every bond in the portfolio for the sponsor when they can make money doing it. But nothing requires them to do this other than the profit motive.
If one or more of the bonds in the portfolio, can’t be sold quickly for fair value, the specialists will usually just wait as ETF prices continue to drop until the added risk is offset by the larger price spread. The specialists must be willing to take bonds from the ETF sponsor and resell them or there is no cash for the selling investor.
The system works pretty well when investors are buying. But how liquid are ETFs when it comes to selling? The market has not been tested, so no one knows. But we do know the underlying bonds are not very liquid.
My understanding of markets says the professional specialists that provide equilibrium in normal markets will flee, leaving investors to fend for themselves in a market panic, creating stunning losses in a matter of minutes. We’ve seen it several times in stocks over the past few years, and with bond prices at crazy, nose-bleed levels, when it happens to the bond market it will get really ugly, really quick.
Investors expecting a special wrapper (ETFs) around illiquid investments to magically create liquidity where there is none are fooling themselves.
What the Markets Are doing
US stock markets staged an impressive, but short-lived rally following the market dive after the June 27th British vote to leave the EU, but it sort of ran out of gas in the 2 weeks ending July 29th. Although there were frequent headlines of “new highs” the total of the highs didn’t amount to much and the number of shares being traded dried up.
Low-volume rallies like this one occur not because of buying demand, but because fewer sellers happen to show up for a little while. The point being, it is not the sign of a strong market. With election jitters and the market’s weakest months coming up, it is very possible we will see a declining market for the next few months.
European markets are still below where they were before the British vote to leave the EU. Japan’s market, despite being buoyed up by the government’s buying of stocks, still struggles to make gains. I’ve never seen a government buy stocks in the open market like this, and I’m not sure what the end game will be, but I can’t imagine it will be pretty for their stock market.
Interest rates, here and abroad, continue to be pulled down as central banks in both Europe and Japan work the levers of power.
Investors are faced with the decision to lock money up in banks with negative rates, or buy something. That is what the Central Banks are trying to do, get some money to chase some goods, and get safe money to move in to riskier investments. That money fleeing Europe is the likely cause for our stock market’s jump after Brexit.
Gold prices have weakened lately as gold enters a time when multiple cycle lows are pulling it down.
"...investors expecting a special wrapper (ETFs) around illiquid investments to magically create liquidity where there is none are fooling themselves."
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The Political Season is Here
A topic that I expect to see get attention in the current political season is the income disparity between corporate CEOs and the average worker. Modern Trader magazine recently had an extensive article about this topic and here are a few excerpts I found enlightening.
Although only 17 women appeared among the 341 executives in a 2016 S&P 500** CEO Pay Study, those women averaged $18 million in compensation while the men averaged $10.5 million. You go girls!
The disparity between worker pay and that of the top brass is nothing new. According to the article, CEO pay increases between 1980 and 2013 have actually gone up at the same rate as increases in company values (market capitalization, to be specific).
Behind the current level of disparity is a 1992 ruling by the IRS that made salaries over $1 million non-deductible and encouraged greater ties between company performance and executive compensation. This led companies to focus on offering bazillions in stock options in their CEO compensation packages.
Outspoken Mark Cuban suggests paying CEOs in cash – enough cash for them to buy stock and options without diluting shareholder equity.
He also suggests reducing government subsidies, tax breaks and concessions to companies who pay wages so low that their workers qualify for government support. Right now the government is subsidizing both the workers and the companies which makes little sense. This could encourage corporate America to increase wages for workers, reducing the wage disparity from that end.
This was a new idea that makes sense to me.
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What's Going on in Your Portfolio?
From my comments, elsewhere, about the dim outlook for the markets over the next few months you might be wondering if I am raising cash or buying inverse investments to make some money if the market declines. The answer is yes to both of those questions.
Shock Absorber Growth* portfolios made small gains in July, adding to their already nice gains for the year.
Flexible Income* portfolios had a strong July, and are close to double digit gains already this year.
My blended Portfolios, Adaptive Balance* (currently 60% Income, 40% growth) and Adaptive Growth* (currently 70% growth and 30% income) are also showing gains for the month and year.
Due to the recent stock market rally, the calculations that drive our investment mixes (60/40, etc) are saying that more exposure to the stock market is in order, but I have decided to hold off and stay a little conservative due to market weakness we normally see at this time of year.
Let's shirink things down. Here's what Velcro looks like close up:
What We Were Saying Back Then
In late 2013 I cautioned investors that Tesla (Ticker: TSLA) was producing more smoke and mirrors than cars. Now, almost 3 years later my opinion has not changed.
Tesla still has not produced a profit. The money it would take to buy every Tesla share (called market capitalization) is $38 billion, just below Ford motors which produced a $23 billion gross profit last year and is sitting on $39 billion in cash. The book value, what Tesla assets would fetch if the company were closed down is only $1 billion. Ford’s is $30 billion. There is not much value in TSLA.
Tesla's stock price has changed little in the past 2 years, except for several 30% price drops. That means lots of risk with no reward. Not what I call a good investment.
Tesla is what I call a story stock. No real value, just a sexy story. Normally story stocks are penny stocks or Internet startups. To have a $38 billion story stock is extraordinary and reminds me of the 1841 classic book by Charles Mackay called Extraordinary Popular Delusions and the Madness of Crowds. He focused on tulip bulbs and such, but chapters could be written about our tech mania in 1999 and Tesla, today.
Paul Santos, in a Seeking Alpha article, reports Tesla is losing reservations for its new Model 3 at a rate of around 28,000 per month, which if true, is a very significant problem for Tesla. In addition, Consumer Reports indicates buyers should expect a much worse than average reliability from Tesla Model S.
Tesla buyers have to have lots of time and money on their hands. It takes 30 minutes to charge a Tesla after you find a charging station, vs. how long does it take you to fill up your car? And for this you pay up to $110,000 for Tesla’s Model S. Tesla remains a rich boys toy, and has not reached the level of practicality required to become mainstream.
If you own Tesla stock, be sure you can do without that money if the stock price declines to its true value, because I think that is a very real possibility.
Disclosure: I don’t own Ford or Tesla stock for myself or for my clients.
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