AAII Investor Update: Bringing Down the Bond Yields

Thursday, June 21, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 32.9%, down 1.1 points
  Neutral: 31.2%, up 1.1 points
  Bearish: 35.9%, up 0.1 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Yesterday, Ben Bernanke and company again befriended borrowers and remained the enemy of savers.

The Federal Open Market Committee announced plans to buy long-term Treasury bonds and sell short-term Treasury notes. Specifically, the Fed will buy Treasury securities with maturities of six to 30 years and sell or redeem Treasury securities with maturities of three years or less. The intent is to bring long-term interest rates down, closer to short-term rates. Bond experts refer to this as a flattening of the yield curve.

A yield curve plots the yields of similar bonds with different maturities. A common yield curve plots yields for three-month, six-month, 12-month, two-year, five-year, seven-year, 10-year and 30-year Treasury notes and bonds. Under normal economic conditions, the curve will slope upward, with rates rising as the maturities lengthen. Given expectations for higher interest rates and stronger inflation in the future, investors would want a higher yield for a 10-year note than they would for a two-year note.

When investors expect slow economic growth and stable inflation over the long term, the yield curve can flatten. The flatter the curve, the less difference there is between short- and long-term bond yields. (If investors expect interest rates to fall in the future, the yield curve can even become inverted, with long-term bond yields below those of short-term yields.)

So why would Bernanke want to flatten the yield curve? I asked this question yesterday of Michael Hasenstab, a fixed-income manager for Franklin Templeton who spoke at the Morningstar Investment Conference. Michael confirmed my initial reaction to the FOMC’s announcement: Bernanke is trying to create liquidity as well as inspire confidence that he will do whatever is in his power to fend off a double-dip recession.

The Fed chairman is increasing his bet that if long-term interest rates are low enough and banks have enough access to capital, lending will pick-up, thereby spurring economic growth. It is painful medicine for savers that runs the risk of leading to higher inflation in the future. It is also questionable as to whether this latest move will have any significant effect, especially since the Fed will only be able to buy $267 billion of longer-term notes and bonds. On the other hand, we can only guess what the economy would be like if Bernanke were not acting aggressively.

From a portfolio standpoint, dividend stocks can help offset the lower yields. But, you should remember that bonds provide preservation of capital and therefore deserve a role in your portfolio, even if the yields remain painful.

AAII Model Portfolios Updated

There were no new transactions in the model portfolios.

The year’s strong start is now firmly in the rearview mirror, with May extending the monthly market losing streak to two months. Once again, smaller-cap stocks underperformed larger-cap stocks. Last month, the Model Shadow Stock Portfolio was unable to buck the trend, and recorded its first loss of the year.

During May, the Model Shadow Stock Portfolio declined 9.0%. The Model Shadow Stock Portfolio underperformed both the Vanguard Small Cap fund (NAESX), which lost 6.8% and the DFA US Micro Cap fund (DFSCX), which lost 7.0%. For the year, the Shadow Stock Portfolio is now up 9.1%, outpacing the 4.3% gain achieved by the Vanguard Small Cap fund and the 2.9% gained by the DFA US Micro Cap fund.

The Model Mutual Fund Portfolio fell by 5.5% in May. This compares to the Vanguard Total Stock Market fund (VTSMX), which lost 6.2%. For the year, the Model Mutual Fund Portfolio is up 3.2%, while the Vanguard Total Stock Market fund is up 5.2%.

The Model ETF Portfolio lost 7.4% in May, which compares to the 80% SPDR S&P 500 ETF (SPY) and 20% iShares MSCI EAFE Index ETF (EFA) benchmark, which lost 7.1%. For the year, the Model ETF Portfolio is up 1.7%, while its benchmark is up 3.3%.

AAII’s Model Portfolios provide stock, mutual fund and exchange-traded fund (ETF) research and analysis. These are real-money portfolios that serve to illustrate the approaches that an individual investor can follow.

See the AAII Model Portfolios.

More on AAII.com

The Week Ahead

About 10 members of the S&P 500 will report earnings next week. Included in this group are Monsanto (MON) and Paychex (PAYX) on Wednesday, Accenture (ACN) and Nike (NKE) on Thursday, and Constellation Brands (STZ) on Friday.

The first economic report will be May new home sales, which will be published on Monday. Tuesday will feature the April S&P Case-Shiller home price index and the Conference Board’s June consumer confidence index. May durable goods will be published on Wednesday. Thursday will feature the final revision to first-quarter GDP. May personal income and spending and the final University of Michigan consumer confidence survey will be published on Friday.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five year notes on Wednesday and $29 billion of seven-year notes on Thursday.

No Federal Reserve officials are currently scheduled to speak.

AAII Sentiment Survey

Bullish sentiment declined slightly, while bearish sentiment was essentially unchanged in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.1 percentage points to 32.9%. This is the 12th consecutive week that bullish sentiment has been below its historical average of 39%.
br /> Neutral sentiment, expectations that stock prices will fall over the next six months, rose 1.1 percentage points to 31.2%. This puts it about even with the historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, edged up 0.1 percentage points to 35.9%. This is the 10th time in 11 weeks that bearish sentiment has been above its historical average of 30%.

This is the longest streak of consecutive below-average readings for bullish sentiment since a 14-week stretch from December 20, 2007, through March 20, 2008. Many individual investors remain fearful that further declines in stock prices could occur. Worries that the European sovereign debt crisis and a slower pace of U.S. economic growth will lead to a repeat of last summer’s correction are keeping pessimism at above-average levels.

This week’s special question asked what the Federal Open Market Committee should do over the next few months, if anything, to help the U.S. economy. (The results were tabulated before yesterday’s FOMC meeting statement was released.) Most respondents said the Fed should do nothing. The reasons varied from a belief that additional stimulus won’t help to worries about the potentially negative effects that previous stimulus actions will have to opinions that the Fed should wait for events in Europe and the November elections to unfold.

Among the small number of respondents who thought the Fed should act, most thought more stimulus should be provided. Some, however, thought the Fed should allow interest rates to rise.

Here is a sampling of the responses:

  • “No additional quantitative easing. I doubt it will work.”
  • “Nothing. The Fed has done enough.”
  • “Leave us alone and stop printing money.”
  • “Nothing, other than continuing to watch the economy and being prepared to act.”
  • “I don’t think Bernanke has many options left.”

» Take the sentiment survey