AAII Journal Editor
Tug of War in the Bond Market
Strategies for protecting your portfolio against interest rate uncertainty.
These real-world portfolios have solid performance track records and are a great educational tool for our members.
AAII members discuss how they use the model portfolios.
Federal Reserve Chairman Ben Bernanke continues to be the enemy of savers. Yesterday, the Boston Red Sox fan reiterated his belief that interest rates should be kept at rock-bottom levels for an extended period of time. He views this as necessary in order to keep the economy growing.
Part of Bernanke’s problem has been his inability to accelerate the pace of money movement, or velocity. Velocity is an economic measure of how many times a dollar is used to purchase goods and services. For instance, if I give you a $100 bill and you put it into your dresser, there is no real velocity. However, if you use it to make a repair on your car and then your mechanic spends the cash on buying a replacement part, velocity accelerates. Thus, there are advantages to sustaining a certain level of velocity.
An example more applicable to the current environment is the housing market. The National Association of Realtors reported a 3.8% decline in existing home sales and a 4.6% drop in home prices on Tuesday. A homeowner who cannot sell his house, either because he is underwater on his mortgage or simply can’t find buyers for a price he wants to sell at, has capital that is stationary. He is therefore unlikely to buy someone else’s house, much less spend additional money on items and services often associated with a home purchase. Thus, the capital tied up in the homeowner’s current house is not circulated back into the economy, thereby slowing velocity.
How slow is velocity currently? The chart below, from the St. Louis Federal Reserve Bank, shows the long-term trend in M2 money stock velocity. (This is the ratio of quarterly nominal GDP to the quarterly average of M2 money stock. M2 is a broad set of financial assets, including cash held outside of depository institutions, savings deposits, and money market accounts. Nominal GDP is economic growth that has not been adjusted for the impact of inflation.) The gray bars show when recessions have occurred.
As you can see, velocity is at historically low levels. Velocity is, however, just one snapshot of the economy and not a sole indicator you should rely on. However, when you factor in other signposts, a picture of money not changing enough hands is formed. For example, economist Lawrence Yun complained about “overly restrictive loan underwriting standards” in the National Association of Realtors’ existing home sales press release. At the same time, U.S. corporations remain apprehensive about spending money, particularly when it comes to hiring, despite having large cash balances.
In simplistic terms, Bernanke’s hope is that if money is both cheap and accessible, velocity will eventually increase, thereby spurring growth. The short-term downside of his policy is that bond rates are staying at historically low levels. The long-term danger is that inflation will jump, forcing the Federal Reserve to hike up interest rates. Though the fed Chairman’s margin for error is large and he has many detractors, we still don’t know what the actual end result will be. Many of you have assumptions, but the future is rarely what we expect it to be.
Bond Strategies for an Uncertain Environment
As the Fed tries to get the economy growing faster and Congress debates the debt ceiling, interest rate uncertainty continues to loom. The good news is that there are strategies you can use for the bond portion of your portfolio, as Marilyn Cohen explains in the June issue of the AAII Journal. She believes variable-rate bonds, high-quality corporate bonds, and intermediate-term bond funds can all help.
If you like her suggestions, you can see her present at this year’s AAII Conference in Las Vegas.
Model Portfolios Updated on AAII.com
As stocks went down for the month of May, the model portfolios followed suit. The Model Shadow Stock Portfolio lost 3.6% for the month, but is still up 4.7% for the year, trailing the DFA U.S. Micro Cap Index fund, which is up 7.8% for the year as of May 31, 2011. However, the Model Shadow Stock Portfolio is still comfortably ahead of the index fund when comparing time frames for one year and longer.
The Model Mutual Fund Portfolio and Model ETF Portfolio lost 1.5% and 1.4%, respectively, in May. The benchmark for the Model Fund Mutual Portfolio is the Vanguard Total Stock Market Index fund, which lost 1.2%. The Model ETF Portfolio is benchmarked against a mix of 80% iShares Dow Jones U.S. Index ETF and 20% iShares MSCI EAFE Index ETF, which lost 1.5% last month.
There were several changes in the Model Shadow Stock Portfolio for the month. Kendle International (KNDL) is being acquired by INC Research, and the stock was sold following board approval. Jackson Hewitt (JHTXQ) filed for bankruptcy and the stock was subsequently sold. Two new stocks were purchased as replacements: Addus HomeCare Corporation (ADUS) and Gilat Satellite Networks Ltd. (GILT).
There were no changes to the ETF or Model Portfolios. As always, you can see the Model Portfolios, their respective buy and sell rules, and performance data in the Model Portfolios section of AAII.com.
See how other members are using the model portfolios on the AAII Discussion Boards.
The Week Ahead
Fewer than 10 members of the S&P 500 will report earnings next week. They are Nike (NKE) on Monday; Family Dollar Stores (FDO), General Mills (GIS) and Monsanto (MON) on Wednesday; and Apollo Group (APOL), Constellation Brands (STZ), Darden Restaurants (DRI) and McCormick & Company (MKC) on Thursday.
May personal income and spending will be the week’s first economic report, with a release date of Monday. Tuesday will feature the Conference Board’s June consumer confidence survey and the April S&P/Case-Shiller housing price index. The June Chicago PMI will be published on Thursday. The University of Michigan’s final June consumer confidence survey, May construction spending and the June ISM manufacturing survey will be released on Friday.
Minneapolis Federal Reserve Bank president Narayana Kocherlakota and Kansas City Federal Reserve Bank President Thomas Hoenig will speak publicly on Monday. Federal Reserve Governor Sarah Bloom Raskin will speak on Wednesday and St. Louis Federal Reserve Bank President James Bullard will hold a press conference on Thursday.
The Treasury Department will auction $35 billion of two-year notes on Monday, $35 billion of five-year notes on Tuesday, and $29 billion of seven-year notes on Wednesday.
AAII Sentiment Survey
This week’s AAII Sentiment Survey results:
Bullish: 37.5%, up 8.5 points
Neutral: 26.8%, down 1.4 points
Bearish: 35.7%, down 7.0 points
Bullish sentiment jumped 8.5 percentage points to 37.5% in the latest AAII Sentiment Survey. This is an eight-week high for optimism that stock prices will rise over the next six months. It is also, however, the 10th consecutive week that bullish sentiment has been below its historical average of 39%.
Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, declined 1.4 percentage points to 26.8%. The historical average is 31%.
Bearish sentiment, expectations that stock prices will fall over the next six months, dropped 7.0 percentage points to 35.7%. This is a three-week low for pessism. Nonetheless, bearish sentiment is above its historical average for the 17th time in 18 weeks.
An end to the market’s six-week losing streak gave individual investors hope that stock prices are stabilizing. Even with the improvement in sentiment, pessimism remains high and is above average for the longest period of time in approximately a year. (Bearish sentiment never dipped below 30% during the 18-week period of from May 13 to September 9, 2010.) The failure of Washington to reach an agreement on the debt ceiling and the slow pace of economic growth remain key concerns for individual investors.
This week’s special question asked AAII members if the economy has merely slowed or if the risks of a double-dip recession have increased significantly. Approximately two-thirds of respondents said the economy has slowed, but will not fall into a double-dip recession. One-third said the risks of a double-dip recession have increased.
Here is a sampling of the responses:
- “The economy has only slowed—it would take another economic shock to take us back into a recession.”
- “The economy has merely slowed, in part due to Washington’s wrangling. Resolve the debt ceiling so we can move on.”
- “The risk of another recession has increased, but I believe there is still less than a 50% chance of it occurring in the next 12 months.”
- “The risks of a double-dip recession have significantly increased. The government does not know how to fix the economy.”
- “However the recession is described, the economy cannot recover until millions of decent paying jobs are created.”
Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.