Other Finance

  • Some Thoughts On the Inverted Yield Curve

    For decades, one of the most accurate measures for predicting a recession has been when short-term yields on Treasuries exceed those of the longer-term bonds. Many believe the yield curve is a reliable indicator of an upcoming economic downturn. This is becasue the short-term side of the yield curve is mainly driven by Federal Reserve policy that refleccts current economic strength; the long-term side of the yield curve—10-year and longer matiurity Treasuries, by comparison, is thought to indicate bond investors’ long-term views of the market as well as inflation expectations.

    An inverted yield curve has preceded each of the last seven recessions as measured by the National Bureau of Eonomic Research.

    As such, whenever the dreaded inverted yield curve rears it’s ugly head, investors understandably start to panic. Over the past year, the yield curve has inverted several times — albeit for very shot durations. Is a recession imminent if the curve inverts for a few days? Is there a minimum duration for which the yield curve must be inverted prior to a subsequent recession, that may follow anywhere between a few months to two years.

    What part of the yield curve one looks at matters as well: is the comparison between the three-month bill and 10 year note the definitive standard to

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    use?

    Prof. Campbell Harvey of Duke University analyzed inversions in the 1980s and concluded that the 10-year/three-month relationship or correlation, was the best part of the curve to use. For those investors who panic the instant an inversion occurs, he also concluded, that it needs to be inverted on average over a quarter to provide a solid signal, not just for a few days—let alone just part of a day.

    Could the inverted yield curve no longer be a reliable indicator of an imminent recession? in th is regard, it is instructive to note that a number of factors that were not present during the past seven recesssions. First, interest rates were certainly not at the historically low present levels when the curve inverted. In this regard, Ii is perhaps interesting to note the 10 year Treasury bond yield recently dipped below 1.25%, the lowest it has ever been.

    The bull market of the past decade was in large part fielded by the massive quantitatie easing policy of the Federal Reserve. The Fed arguable, kept the money supply spigot open for fa too long. As a result, interest rates have remained at historically unprecedented low levels. Because of the extended duration of the of the Fed’s easy money policy, investors becam acclimated to historically low rates and their expectations were that rates would remain perpetually low. This proved to be a boon for the stoc market as the return on fixe-income investments was negligible. Not only did the Fed keep interest rates relatively low, European central banks went a step further and continued their quantitative easing, so much so, that the Continent has had negative interest rates for the past several years.

    The unprecedented negative interest rates on sovereign bonds around the globe could be one of the reasonss why short-term Treasurey yields exceed long-term rates. Additionally, investors expectations for inflation are certainly not the saame as they have been for the past thirty years. Indeed, there are those who argue, that the days of rampant inflation of the Volcker era are over. Inflation has stubbornly remained below the Fed’s 2% rate for the past three quarters. The persistent low levels of inflation could be another factor that could help explain the recent yield curve inversions.

    There have been mixed signals concerning the health of the economy: consumer spending and confidence remain high, even if manufacturing capacity is starting to taper off. The market is uncertain as to which direction the economy is headed. It is important alos to remember, the Fed has very little room fo cut rates further. That raises another issue: will negative interest rates start to appear in teh United States?

    Another factor that has been determinative of the Fed’s interest rate policy has been the reaction of stock market to any bad news on the trade front or the prospect of slowing global growth, that may ultimately impact the U.S. economy. The Fed, in a very real sense has been a hostage of the stock market. When it did an abrupt about-face in January and shelved its plans for another interest rate hike in the face of a market meltdown, Fed chairman Jerome Powell, though he won’t admit it, is overly solicitous of investor sentiment and wishes for rate cuts.

    This is another determinative factor that impacts the level of short-term and long-term rates.

    All of these factors need to be taken into account when one attempts to divine the future direction of the economy from an inverted yield curve.

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  • Are Credit Reporting Agencies Doling Out Undeserved Bond Ratings?

    After the carnage of the 2008 financial crisis was over, a lot of finger-pointing among the major Wall Street players ensued in an attempt to assign blame for a catastrophe that few saw coming. One of the prime targets in the fiasco were the staid bond rating firms: Standard & Poor’s, Moody’s, Fitch and a few lesser-known entities. The opprobrium directed at their lax standards for assessing credit risk was well deserved.

    In hindsight, it was apparent that the high credit ratings assigned by these bond analysis firms to some of the securitized tranches of home mortgages grossly understated or ignored the risks associated with these novel debt obligations. The investors who relied on these ratings as a basis for purchasing these instruments suffered great losses and the reputations of the reporting agencies were tarnished.

    Recently, the ghost of credulous default risk ratings has reared its head once again. In a quest to enhance market share, many firms are issuing ratings that minimize the risks to investors who purchase the debt instruments of various corporate issuers.

    This baneful ratings process is reminiscent of the scandalous conflict of interest problems that plagued the accounting industry over 15 years ago, which caused the dissolution of Big Eight accounting firm Arthur Andersen and led to the enactment of the Sarbanes-Oxley Act.

    Even though the credit ratings themselves may be suspect, many investors continue to rely on the risk assessment assigned by these firms. Federal Reserve Chairman Jerome Powell has, on numerous occasions, made no secret of his concern about high corporate debt levels and unreasonably high credit ratings.

    During a May 2019 speech, Powell likened one of the hottest debt instruments today, collateralized loan obligations, to pre-2008 crisis mortgage-backed debt. As Powell noted, “Once again, we see a category of debt that is growing faster than the income of the borrowers even

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    as lenders loosen underwriting standards.”

    What regulators failed to address post-2008 was the inherent conflict of interest in the corporate credit review process, where issuers also pay for the ratings. This is like putting the fox in charge of the henhouse. This endemic structural flaw is eerily reminiscent of the questionable reliability of the financial statement certifications major accounting firms gave house-of-card companies such as Enron, which resulted in enormous investor losses.

    Accounting firm shopping was common by corporations at that time. Firms such as Arthur Anderson had long-term lucrative IT consulting contracts with the same companies whose financial statements they would be auditing. Accounting firms were reluctant to jeopardize such profitable arrangements by producing unfavorable audits.

    The evidence is rather damning. The pious assertions made by the rating agencies to the contrary that, in some situations, ratings firm shopping can lead to vastly different credit-worthiness scores on the same debt instrument. A good example of this credit risk analysis non sequitur is the Four Seasons Resort in Hawaii, which features oceanfront suites that can go for as high as $14,500 per night. The resort actually incurred more debt, yet obtained a higher credit risk rating.

    In 2014, the resort’s investment bankers selected Morningstar to rate the company’s $350 million bond offering, collateralized by the property’s mortgage. Morningstar gave ratings to six tranches of the aggregate debt instrument, which ranged from triple-A, the highest rating accorded a corporate debt obligation whose likelihood of default is remote, down a remarkable 14 rungs on the ratings ladder to single-B, which denotes the bond issue is susceptible to losses in a mild recession.

    Investment bankers are highly visible players in the shop-for-ratings corporate financing scheme. When the Four Seasons refinanced its obligations in 2017, in a $469 million deal, the resort’s investment bankers selected DBRS as one of two ratings firms chosen to assess the credit risk of the new debt. In a remarkable “coincidence” prior to that bond sale, DBRS relaxed its standards for such “single-asset” commercial mortgage deals issued by the resort.

    DBRS gave credit worthiness grades three rungs higher than on comparable tranches of the mortgage debt rated by Morningstar in 2014. According to Commercial Mortgage Alert, an industry publication, DBRS’s market share of the ratings business doubled to approximately 26% shortly after its ratings revisions.

    Any suggestion by ratings firms that the concomitant increase in market share after loosening credit review standards is merely happenstance strains credulity. After the DBRS ratings changes, unsurprisingly, Morningstar was not about to watch its market share erode because of its lower ratings. It offered to do penance for its temerity in assigning a relatively lower rating than DBRS’s score on the same pools of single-asset commercial mortgage debt.

    In June 2018, Morningstar revamped its credit worthiness methodology for these commercial single-asset, mortgage-backed deals, swiftly recouping its market share. Even though Four Seasons’ income had increased since 2014, the additional debt meant various slices of the new offering had less cash on hand to repay investors than it had available in 2014. Morningstar issued ratings almost two rungs higher on comparable slices of the same debt rated by DBRS back in 2017.

    After receiving the more favorable rating, Morningstar was one of two ratings firms Four Seasons’ investment bankers picked to rate its next debt offering in 2019, a lucrative $650 million contract.

    Any assertion by the credit agencies that the converse is true, namely, some issue ratings by one credit review company are substantially lower than that of other firms, is wholly inconsistent with the evidence. One way to test how frequently lower ratings are assigned overall is by reviewing the commercial, mortgage-backed debt instruments, of which investors hold approximately $1.2 trillion.

    A statistical review by The Wall Street Journal revealed that DBRS rated these particular bonds higher than S&P, Moody’s or Fitch approximately 39%, 21% and 30% of the time. DBRS issued lower bond ratings approximately 7% of the time. Morningstar rated the bonds higher than the big firms at least 36% of the time and lower 2% to 8% of the time. Kroll, another smaller ratings firm, showed similar results.

    Given the glaring, maximize-market-share conflicts of interest that drives the entire ratings process, the best way for investors to assess the default risk of each issuer is to ignore the ratings issued by the credit ranking firms and, instead, consult and read thoroughly the statutory Securities and Exchange Commission disclosure documents or registration statement. This document contains copious and detailed explanations concerning the potential risks for each corporate debt offering.

    Any issuer of corporate debt to the public has liability exposure under the Securities Act of 1933 as well as SEC rule 10b-5 for false or misleading statements in connection with a new bond offering. Registration statements are carefully drafted by counsel to ensure that information contained about the offering does not minimize nor misstate the risks.

    The mandatory disclosure document presents a far more realistic appraisal of the issuer’s credit worthiness that any market share-sensitive firm’s rating can provide. The reasons why are that under the securities laws, not only is the issuer liable for any material, misstatements or omissions concerning the risks of the offering made in its registrations statement, but the investment bankers underwriting the issue are secondarily liable as well.

    Until structural changes are made to the rating process, investors should be mindful of high-risk corporate borrowers, whose rosy ratings do not accurately reflect the default risks in connection with the associated offering.

    About the author:

    John Kinsellagh

    John Kinsellagh is a freelance writer, former financial adviser and attorney specializing in civil litigation and securities law. He completed the Boston Security Analysts Society course on investment analysis and portfolio management.

    He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

     

    He is the author of “The Mainstream Media Democratic Party Complex” and “Election 2016,” both available on Amazon. Follow him on Twitter @jkinsellagh.

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  • Federal Reserve Is Now Hostage To the Stock Market

    For the past three weeks, investors have been eagerly waiting for an indication by the Federal Reserve that an interest rate cut would be imminent in the very near future.

    Fed chairman, Jerome Powell, discounted the good economic news, stating that the positive factors, continuing low inflation, which has consistently been below the Fed’s 2% target rate and low unemployment, were insufficient reasons, in his opinion, to offset the unforeseeable risks a rupture in the trading relationship between China and the U.S. would have on the economy. Since a trade agreement with China now appears rather remote, the Fed must take into account risks to the economy that were not as imminent as they were two months ago.

    Shortly after Powell’s announcement that the Fed was leaning towards a rate cut after its July 31st meeting, investors began switching over to riskier assets, which they believed had the blessing of the Fed.

    After Powell’s comments, like spoiled children, investors acted as if a rate cut of 50 basis points was somehow foreordained. Indeed, judging by some of the articles in the Wall Street Journal, Barrons and other financial publications, some investors were talking as if it was their divine right to be coddled by the Fed and receive a hefty rate reduction. In late June, the fed funds futures market put

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    the probability for a ½ point rate cut at 45%. This nonsense was quickly dispelled, but it is an indication of investors’ unrealistic expectations in terms of how obliging the Fed should be towards their desires to continue to ride the tail- end of the ten-year bull market.

    The Fed has been reluctant to raise rates for fear of inducing a slowdown in consumer spending that has occurred every time it signals a rate increase or if there is a perception it is not acting quickly enough in adjusting its neutral rate when economic conditions rapidly change.

    Today, the spending habits of many consumers are linked to the changing status of their net worth. The number of consumers with 401k an IRA retirement accounts, has skyrocketed over the past thirty-years. When the stock market goes down, it doesn’t just impact the 1% income bracket, it affects a fair number of American households whose retirement accounts are invested in the market.

    When retirement accounts are down, it can make some consumers feel their disposable income is down as well.

    The problem with the Fed’s posture, is that it encourages investors to purchase risky asset classes, with the expectation, not entirely unwarranted, that the Fed has their back, when conditions turn for the worse. Investors feel that because of the historically elevated importance of the stock market on rate policy, the Fed will never raise rates, when it might cause a massive drop in risky asset classes, such as junk bonds.

    Powell has clearly indicated in the past, that an inverse bond/equity relationship leading to asset class mispricing, can create a dangerous bubble that can lead to economic downturns. He now seems to have let his concern about the dangers of a boom bust cycle fall by the wayside. Though Powell may continue to warn of the dangers of holding a disproportionate amount of risky assets, he understands, in terms of monetary policy options, his hands, currently are tied .

    So, while Powell may warn investors that the Fed will not bail them out for making poor investment decisions, his counsel is given, with a wink and a nod.

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  • The Enduring Principles of Graham and Dodd


    Although financial markets have been transformed in ways unimaginable since Benjamin Graham and David Dodd published the first edition of “Security Analysis” in 1934, the lessons that can be learned by gleaning its pages are timeless. A review of only a few of the underlying principles upon which their value investing philosophy is based will reveal whether the stock being analyzed is Facebook (NASDAQ:FB) or Boeing (NYSE:BA), whether the market is in the throes of a roaring bull market or in a cyclical downturn. Analysts can benefit greatly by incorporating these maxims in their quest for ascertaining a stock’s intrinsic value.

    One of the underlying tenets of “Security Analysis” as Seth Klarman (Trades, Portfolio) appropriately noted in the Preface to the sixth edition is that, “The real secret to investing is that there is no secret to investing…that so many people fail to follow this timeless and almost foolproof approach enables those who adopt it to remain successful.”

    For the past decade, with the caveat of exactly how one defines certain terms that form the basis of the analysis or comparison, many within the investment community contend that value investing has failed to keep up with growth or momentum investing.

    A roaring, historically unprecedented, 10-year bull market that has heavily favored the tech stock sector would seem to validate such a proposition. However, there is nothing in the lessons enumerated in Security Analysis that contain any suggestion by its authors of an inherent bias towards one sector versus another. What is paramount for successful investing is the relationship between price and value.

    A central thesis that underlies their entire treatise on value investing is Graham and Dodd’s approach or consistent methodology for apprising whether a contemplated purchase of a security can be characterized generally as either an exercise in speculation or a bona fide investment. Put another way, will the investor receive “value” for his money? This paradigm for investing is useful even today, regardless of which sector or particular stock is fancied by Wall

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  • Who’s In Control? The Federal Reserve Or the Stock Market?


    As the historically unprecedented bull market crosses over the ten year mark, what explains the continuing vitality of the stock market? Will the rally never end?

    Comments made by federal reserve chairman, Jerome Powell in December 2018 that the fed was leaning towards making two additional 25 basis point rate hikes in 2019 sent the market into a tailspin as 2018 drew to a close. Despite previous Powell’s previously stated position that the fed was not in the business of maintaining a bull market, he relented and abruptly quashed the idea of any 2019 rate hikes.

    Undoubtedly, the reaction — or overreaction — was due to investor unwillingness to believe that the halcyon ten-year period of zero-interest rates was finally over. The extent of the selloff can be explained, in part, by the fact that a decade of unfettered quantitative ie easing by the fed, led to a mismatch in asset pricing; an inverse bond/equity relationship took hold.

    As the yield on alternative, fixed-income investment vehicles barely pierced the 1% threshold. Investing in risky assets during this easy money period, in essence, implicitly had the fed’s blessing. In earlier comments, made in 2018, Powell noted that he was more concerned with asset misplacing than in runaway inflation; he believed investor speculation could have adverse ramification for the economy.

    The current posture of the fed in conjunction with investor’s confidence that the low rate environment will remain unchanged, has created a bizarre stasis or equilibrium . As long as the fed remains concerned or circumscribed by its fear of causing another October bloodbath, the more comfortable, or less circumspect investors become for favoring riskier assets like stocks and below investment grade corporate bonds.

    This symbiosis provides support for a market in which tech stocks continue to rise beyond their previous all-time highs.

    Where this will all end, only time will tell.

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  • What Happens if Corporate Profit Margins Start to Decline?


    Before 2018 drew to a close, those analysts not mesmerized by the steady and considerable rate of profit margin growth were already adjusting their first-quarter and annual 2019 margin projections downward. After record-setting increases in 2018, several factors will coalesce to break the favorable decade-long trend that has supported historically high margin levels.

    Some of these factors are already working their way to the corporate bottom line, crimping profits. Unprecedented low unemployment has increased the bargaining power of employees — this is despite the long-term decrease in the number of employees that are union members. The past several years have seen wages rise on a percentage basis that is the highest in 30 years. According to the U.S. Labor Department, average hourly wages in February were 3.4% higher

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  • Does an Inverted Yield Curve Always Precede a Recession?

    The yield curve inverted recently, when the gap between 10-year and three-month Treasuries narrowed and finally disappeared, ending with the three-month yield higher than the 10-year note. The gap, or premium investors demand for holding the longer-term Treasuries, had been narrowing for the past year.

    An inverted yield curve has been a reliable indicator of past recessions, having inverted before each of the last seven recessionary periods according to the National Bureau of Economic Research.

    There are several factors, however, that need to be considered before a recession can be reliably predicted. In short, although an inverted yield curve may provide a tight correlation between changes in interest rates and a looming recession, anticipating exactly when a downturn will occur after the inversion is an inexact science. According to data from Bianco Research, past recessions have been preceded by inversions that lasted for 10 days straight. Should the 10-year yield rise back above the three-month Treasury bills and the inversion is broken,

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  • Investors Flock to Emerging Markets

    Ever since Jerome Powell announced an abrupt reversal in the fed’s previously stated intention to raise rates in 2019, investors have whipsawed in and out of low risk funds to riskier asset classes. Shortly after the fed’s change of heart, many investors seemed to believe they were given the go-ahead to jump back in to risky assets that had been market favorites during the long bull run of the past decade.

    In the wake of the fed’s January announcement, many investors subsequently became afflicted with bipolar disorder, jumping in to asset classes from which they had only recently exited with alacrity due to market volatility and

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  • Is Procter & Gamble Worth Its Premium Price?

    Procter & Gamble Co. (NYSE:PG) posted good results for its latest quarter, exceeding analyst expectations for some measures.

    Earnings per share were $1.21, beating the consensus of $1.21. At $17.44 billion, net sales remained unchanged from the prior year. The company’s sales were not uniform across all its segments. While the beauty products logged an 8% increase in organic sales

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  • Investors Rush Back Into Junk Bond Market

    Squeamish from a dramatic market rout late last year, high-yield bond investors are once again entering the junk market, courtesy of the recent rate increase reversal by the Federal Reserve. Many of these investors substantially increased the cash portion of their portfolios in December in response to steep declines in the market as well as continuing concern over the trade dispute with China, a slowing global economy and uncertainty

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