Wednesday, January 11, 2017

Thoughts About 2017- Leaning More Toward Preservation of Capital/ 2016 Performance Numbers

1. Thoughts About 2017: I am not someone who experiences the phenomenon known generally as "animal spirits". Left Brain does not allow for that. TrumpEuphoria will pass as the real world starts to throw cold water on the economic nirvana now predicted by the thundering herd. 

I am far more positive on the U.S. economy in 2017 than on the U.S. stock market, as I recently outlined in this post:  Update For Portfolio Positioning And Management 2016 4th Quarter - South Gent | Seeking Alpha

I will make a bold prediction for 2017. The iShares 7-10 Year Treasury Bond ETF (IEF) and SPDR® S&P 500 ETF (SPY) will both have positive returns in the first quarter and negative real total returns for the year. 


I increased my exchange traded bond and preferred stock basket by over $40K late last year based on an opinion that prices had fallen too far, too fast. I have already started the process of harvesting some profits, primarily in the Canadian reset equity preferred stocks that I started to buy last February. 

The ten year treasury started a parabolic increase in yield during mid-summer last year, rising from 1.37% (7/5/16) to 2.6% (12/15/16). Daily Treasury Yield Curve Rates That move resulted in 10% to 20% declines in several long duration exchange traded bonds and potentially perpetual fixed coupon equity preferred stocks which caused me to start a minor allocation shift into those securities as trades. I announced that allocation shift in my Comment blogs at SeekingAlpha and discussed the purchases there as well. (e.g. see my comments at South Gent's Comment Blog # 6: REITs, Preferred Stocks And Bonds, Regional Banks, Healthcare & Biotechs, CEFs, Currencies And International Trading - South Gent | Seeking Alpha)

It is important IMO for fixed income investors to recognize that the bond bull market started in 1982 and interest rates are at extremely low levels now throughout the developed world. This long term secular bull market has either already ended or will soon end. The last long term secular bond bear market lasted 32 years starting just prior to my birth.   

It is also important to recognize the many inflationary pressures that are building in the U.S. economy;  the overall increases in inflation expectations reflected in the pricing of 5 and 10 year TIPs; and the gradual removal of  extremely dovish FED monetary policies and a slow motion return to more normal policies. 

The breakeven inflation rate is the market's prediction of the average annual CPI rate.

Currently, a rise in U.S. intermediate and longer term rates is being restrained by the abnormal monetary policies of the ECB, BOJ and other European central banks that are keeping interest rates at lower levels.  Rates & Bonds - Bloomberg The ECB's benchmark rate is a negative .4% and QE is still in full swing. 

I am continuing my effort to control interest rate risk using the following strategies:     

1. Floating Rate Securities And Interest Rate Risks: I am buy floating rate securities when adding to fixed coupon ones. Those securities have the potential to increase their coupons during a rising rate period.
Most of the floater purchases have been Canadian reset equity preferred stocks. Some of those reset every quarter at spreads to the 3 month Canadian T Bill which is what I call a pure floater. Others reset every five years at a spread to the five year Canadian bond. For anyone unfamiliar with how the Canadian resets work, I have drag and dropped some recent discussions into the Appendix section below along with some links to prior posts.
I have also added some to my synthetic floater bond position. Those securities are complicated and probably need to be avoided by most investors. I have been buying and selling them since early 2009. They come in two basic flavors. The first are the pure floaters that pay a spread to a short term rate like the 3 month Treasury Bill or the 3 month Libor rate. The others pay the greater of a minimum coupon or a spread over short term rates. Those will require the Libor to increase significantly from current levels to trigger an increase in the coupon, whereas the coupons of the pure floaters will rise along with applicable short term rate.
2: Interest Rate Risk and Small Lot Trading: Another way that I cope with interest rate risk is to buy small lots, average down when prices decline further and potentially sell higher cost lots when and if there is another rally in bonds.
3. Interest Rate Risk and the Investment of All Cash Flow: I will also by using the entire cash flow generated by my bond and preferred stock positions to buy more of the same, provided interest rates continue to trend up. That will increase my yields and cash flow over a period where interest rates are rising in a persistent manner. I do not know now how high rates will go or whether we are only now at the start of a long term secular bear market in bonds.
4. Interest Rate Risk and Individual Bond Ladders: I can mitigate interest rate risk by buying individual bonds using a ladder approach. Most of those purchases will be part of my Short Term Bond/CD Ladder strategy, but I will extend maturities further out in time when and if I am adequately compensated for interest rate risk. 
My bond ladders will use individual TIPs, treasury bills and notes, and mostly high quality investment grade corporate bonds.
The treasury securities are bought either at auction or in the secondary market.
I can participate in treasury auctions directly through one of my brokers who do not charge a commission for those trades (e.g. Fidelity and Vanguard) or through my Treasury Direct account.
5. Interest Rate Risk and Bond ETFs: I am avoiding those bond funds where investors can withdraw funds (net outflows in ETFs and mutual funds) that cause the fund managers to sell securities into a declining market, thereby locking in lower prices and impairing the net asset value per share of the remaining shareholders. I call this form of interest rate risk "bond fund redemption risk". CEF bond funds do not face this particular form of interest rate risks but are exposed to other forms.
Stocks: I have argued for several years now that conditions were ripe for a long term secular bull market in stocks.  When I started to lay out my case to SeekingAlpha readers in late 2012 and early 2013, there were many who questioned my vision about the future (see e.g. my comments at Sorry Bulls, But This Is Still A Secular Bear Market-Seeking Alpha (2/25/13 Published Article); This Summer Slowdown Will Be Different Than The Previous 3 | Seeking AlphaThe Coming Decade Of Stocks, Part 2 -Seeking Alpha; Bret Jensen's article titled Stagflation: Coming Soon To A Market Near You | Seeking AlphaDow 14,000: Are You The Sucker? | Seeking AlphaBeware: A Large Bull Rides A Tiny Elephant | Seeking AlphaAnatomy Of A Market Bubble | Seeking Alpha)

Starting in early 2009 and prior to 2012, I leaned more toward a snap back rally in a long term secular bear market characterization similar to what happened after the 1974 meltdown, while also noting that the characterization did not make any difference for the first two years. The market would be going up regardless of the long term classification. 

The problem now is valuation and the lofty expectations  about the near future that are not likely IMO to happen. 

I would not be concerned with a 25.02 TTM GAAP P/E coming out of a recession. It is worrisome 7+ years into an economic recovery with no recession. The last recession ended in June 2009: The S & P 500 closed at 2,264 yesterday and at 676.53 on March 9, 2009. 

My general reaction to the current market's valuation is similar to past cycles where investors become too euphoric after an extended stock market rally.  It is easy to do when stock risk and recessions seem like ancient relics from the past. Long term stock bear markets, catastrophic stock market declines (defined as a relatively quick 45%+ decline), cyclical stock markets (20%+ declines), corrections (10% to 20% declines) and dips (5% to 10% declines) are regular dinner guests at stock market parties, particularly those thrown by right brain decision making. 

Those  euphoric stages always result in price multiples that are excessive for reasonably anticipated corporate profits. The excesses in valuation may last for several years (e.g. late 1960s and 1990s), but eventually the real world intervenes and throws rivers of cold water to drown the animal spirits.  

Sure, more borrowing and spending by the federal government on infrastructure will temporarily add jobs and some GDP growth in exchange for a continuation of the parabolic increases in federal debt that will ultimately be the unsustainable and will likely lead to another Great Depression after a series of failed treasury auctions. 

Tax cuts for corporations, and a lower repatriation tax, will increase corporate earnings but that will not easily translate into more job growth. Large corporations tend to increase their dividends, share buybacks and executive compensation packages with the savings. Jobs growth will be hard to come by with the nation near full employment now. 

The tax cuts envisioned by the Trump administration will not be for the bottom three quintiles who need extra money to meet daily expenses but will inure as in the past to those in the top quintile and particularly those in the top 1% who will generally refrain from spending the extra after tax income. 

The spending levels for the bottom four quintiles are impacted by other factors. A major boost in disposable income has resulted from the tsunami in mortgage refinancings at abnormally low long term rates. Wages are starting to increase at a faster rate than inflation as the job market becomes tighter and companies have to offer higher wages to non-skilled labor. Confidence about the future plays into consumer spending as well. Disposable income for the bottom 4 quintiles can be materially lifted by higher risk free interest rates given the size of household investments in savings accounts, money market accounts, CDs and treasury bills.  

Just look at this chart-Over $8.85 Trillion in Savings Accounts:

Risk free investments have produced negligible amounts of disposable income for over seven years now. Hopefully, that is starting to change and that will benefit an economy built on consumer spending.

However, it is certainly possible that federal assistance programs that add to disposable income for the bottom two quintiles, and particularly for the lowest, will be cut in the coming years. 

Over the past year, I have been paring my stock allocation and that is likely to continue for as long as the market continues its parabolic up move. I am not close yet to selling all stock positions which did occur in the late 1990s.    

For 2017, I will continue buying stocks as trades and will probably be a net buy of European equities as intermediate or longer term holds. 

While anyone who predicts the future needs to predict often, and maybe one of those predictions will prove prescient, my 2017 prediction is that the Vanguard FTSE Europe ETF  (VGK) will outperform the S & P 500, overcoming early weakness in the Euro, due to better stock valuations in European multinationals compared to their U.S. counterparts and higher prices for European financials, materials and energy sectors. 

2. 2016 Performance Numbers:

My 2016 performance numbers were adversely impacted by a cash allocation that was close to 40% earning almost nothing. The retirement accounts generally fluctuated between a 10% to 15% cash allocation, while two smaller taxable accounts had cash allocations exceeding 50%. 

The Schwab account, for example, has an average cash allocation of about 40% last year. Schwab calculated my 2016 account standard deviation ("SD") at 6.84 and the total return at 9.64%: 


That account will be managed to keep the SD within a 6 to 8 range. 

The SD is closest to a "moderate" portfolio balance defined by Schwab as weightings of 35% in the Barclay's U.S. Aggregate Bond Index, 35% in the S & P 500 index, 15% in the MSCI EAFE Index, 10% in the Russell 2000 and 5% in 3 month Treasury Bills. The 2016 SD for that mix was 6.79 with a 7.41% return. 

While my Schwab portfolio's SD was closest to that moderate benchmark, the portfolio did not resemble those weightings at all. The portfolio's main weighting at 40% was in cash earning less at Schwab than the 3 month T Bill last year.  

Some of the portfolios gain in risk assets resulted from short term trading. REITs, regional bank stocks, exchange traded bonds and preferred stocks contributed to the overall total return. A few commission free international ETFs were detractors from that 9.64% total return.  

My major change for 2017 will be to earn about 1.5% more than Schwab pays for idle cash and to continue an active trading strategy focusing on dividend paying stocks, exchange traded bonds and preferred stocks. The trading strategy will be cost effective through mid-summer due to an abundance of free trades. 

The Fidelity taxable account had a similar cash balance and a similar return of close to 10%. Fidelity has not yet calculated 2016 return numbers. 

Most of the funds used to purchase short term bonds and CDs have been sourced from the Fidelity Government MM fund, which paid almost nothing last year, so income in that account will increase this year over 2016. After draining cash out of that account early last year, and redirecting the funds to Interactive Brokers, I responded to a promotion for 500 free trades over a two year period by adding $100K in new funds, which brought my cash balance starting in August over 50%.  

The remaining positions in the Fidelity taxable account are mostly dividend paying blue chip stocks, a few remaining stock ETFs, several regional bank stock positions with large percentage gains, Canadian REITs, a greatly reduced number of CEFs, and a small number of exchange traded bonds (only 2  equity preferred stocks).  

The IB account, which generally fluctuated between 10% to 20% in cash earning nothing last year, had a time weighted return of 14.24%:


IB does not calculate SD, but I would estimate that the SD is probably closer to the Moderately Aggressive risk category. There will be a lot of trading in that account, with the overall number of owned securities fluctuating between 75 to 125. 

A smaller satellite taxable accounts outperformed the IB account account with a high cash allocation due in large part to the robust year end rally in regional banks, stock selection in the REIT sector, and successful timing of trades (e.g. selling 100 OHI at over $37 bought at less than $30).  The satellite Vanguard taxable account was in line with the Schwab account with a greater cash allocation earning a higher yield. 

The Fidelity Roth IRA was up 27.9% last year. I will be lucky to hit 5% this year after a recent shift out of REITs and regional banks and into TIPs and short term high quality corporate bonds. 

The Vanguard IRA was up  13.7% with a bond centric portfolio. I have flushed out of that account all leveraged bond CEFs late last year and into early 2017 with the exception of GDO. The proceeds are being channelled mostly into short term treasuries and some minor buys of longer duration exchange traded bonds. The cash level has gone up significantly. Vanguard allowed investors to keep the Vanguard Prime MM fund as a non-sweep account which provides a superior income yield compared to other MM funds (e.g. Fidelity Government MM Fund or Fidelity Treasury MM fund, the two options available to individual investors at that firm). 

Compare Vanguard - Vanguard Prime Money Market Fund with the Fidelity ® Government Money Market Fund or the Schwab Bank Sweep (.03% last month) or IB (zero).  

My T.Rowe Price stock mutual funds slightly outperformed in the aggregate my Vanguard stock funds. Both mutual fund accounts have balanced fund exposure. 

The T. Rowe Price mutual fund account was slightly better at a 8.07% total return with close to a 15% cash allocation. That accounts tilts toward a slightly aggressive risk taking category. Last year was hurt by exposure to international funds, weighted close to 20%, including the T. Rowe Price New Asia fund which was up .6%. A conservative balanced fund has the heaviest weighting at close to 20% and that is the T. Rowe Price Capital Appreciation fund. That fund had a 8.22% total return last year:

T. Rowe Price Capital Appreciation Fund (PRWCX) Fund Performance and Returns

The second largest weighting is in the Dividend Growth fund where there are investments going back into the early 1990s but no new money purchases other than dividend reinvestments in over a decade: 

T. Rowe Price Dividend Growth Fund (PRDGX) Fund Performance and Returns

One of the better performing stock funds, which was originally bought in the early 1990s, was the Small Cap Stock fund (OTCFX) at a 18.57% total return:

T. Rowe Price Small-Cap Stock Fund (OTCFX) Fund Performance and Returns

I also own the T. Rowe Price financial sector fund which had a 16.91% total return last year: 

T. Rowe Price Financial Services Fund (PRISX) Fund Performance and Returns

For the Price mutual funds, I prohibit all selling. My only options are to turn on or off reinvestment and to buy using available cash. The reinvestment option has been turned off and I did receive significant year end cash distributions. So far, I have only reinvested $250 of that cash when I added to the Health Science fund (PRHSX) last Friday. Like the Vanguard health care sector fund, PRHSX had a down year:

T. Rowe Price Health Sciences Fund (PRHSX) Fund Performance and Returns

I view PRHSX as riskier than the Vanguard health sector fund due to its larger biotech concentration including a number of clinical stage companies. It also has the potential to soar higher:
2011 11.01%
2012 31.93%
2013 51.4%
2014 31.94%
2015 12.98
2016 (10.35%)

The 3 year SD is 17.01 which is way outside of my comfort zone. The 3 year SD for IEF is 5.47 and 10.72 for the S &  P 500 ETF SPY. That SD is okay in small doses for the OG. 
At the moment, I am more likely to buy that fund than any of the others.

The largest weighting in the Vanguard mutual fund account is their Equity Income fund: 

Vanguard Equity-Income Fund Admiral Shares (VEIRX) Fund Performance and Returns

Other positions are as follows: 

Vanguard Health Care Fund Investor Shares (VGHCX) Fund Performance and Returns

Vanguard Capital Opportunity Fund Investor Shares (VHCOX) Fund Performance and Returns

Vanguard Wellington™ Fund Investor Shares (VWELX) Fund Performance and Returns

Vanguard Star Fund Investor Shares (VGSTX) Fund Performance and Returns

The overall strategy will continue to be to match the S & P 500 total return numbers over a rolling five year period with a balanced portfolio generating substantially more income and a large cash allocation. Stocks, Bonds & Politics: Portfolio Management Goals-Snapshots of Performance Numbers YTD, 3 and 5 Years Cumulative 

That will be an easy bogey to hit for me when the S & P 500 market is up less than 10% or down any amount. I am giving up some return in years like 2013 in exchange for going down substantially less than years like 2008.


  1. South Gent,

    I left a comment about the biotech industry. When Trump speaks people listen because people believe that he will get it done one way or another. When he pledges to rein in the healthcare expenses the free ride of healthcare cost escalation will pause, if not retreat, and the healthcare stock price will be depressed. Would this change your view of the healthcare industry for the next few years.

  2. Y: I did read Trump's analysis of drug costs embodied in his pithy phrase that drug companies are "getting away with murder".

    Trump is full of B.S. It just flows from every pore in his body.

    I seriously doubt that a GOP Congress, dependent to a significant decree on campaign contributions from Big Pharma and philosophically opposed to government price regulations, will pass legislation to control drug prices.

    The most significant threat to price increases is through pharmacy benefit management companies; and their ability to substitute one drug for another unless price concessions are met which inures to the benefit of the PBM through rebates and possibly some benefits flow to PBM members who are inconvenienced by having to switch medications.

  3. I am now signed up for email notification. Happily, I could use a different address than I joined with. So these will come into my regular box.

    Please let me know if my comment comes through (either by posting or letting me know.)

    Hum, I clicked notify me right below here, and it says follow up comments will be sent to my signup email address - which I rarely look at. This may take a little bit to sort out and get set up conveniently.

    1. Emails with the entire post are coming to my new email address! I have a folder for them, and it's quite convenient.

      I am hoping there is a way to get notified when someone posts a comment. That doesn't seem to be happening yet.

    2. I see. Notification for comments is done by clicking the little "notify me" box underneath this box to create a comment. HOWEVER, those notifications only go the the address I signed up with, not the notification address for the blog entries.


  4. SG
    do you still have a poor opinion of CVS?

    thanks sam atman

    1. SAM: I would not use the work "poor". I am just prejudiced when it comes to CVS. The prices in their stores are way too high (same for Walgreens), and I do not understand why consumers bother when there are numerous lower cost alternatives. As to the PBM business, I view it as a racket that raises drug prices and causes PBM members consternation. It is also a cut throat type of business where the major players play musical chairs with each others customers. The stock appears to have topped out in 2015. The PBM business could also be destroyed by the government when and if it decides to fix drug prices. Then, who needs the PBMs.

      The stock has rallied some since it moved into the low 70s. All that I can say is that I am not interested since I am prejudiced.

    2. Thanks. Interesting to hear your take on them. What is PBM?

      I agree, CVS's prices are too high. I don't spend much time in Walgreens so don't have much breath, but a couple items have been reasonable there. (Including a script that's not covered by insurance. They were the ONLY reasonable pharm.)

      I don't know why people buy there either. There are so many other places to get the same products. They do carry some brands and sizes that Walmart and Target and Kmart don't.

    3. LMH: PBM stands for Pharmacy Benefit Management. I am referring to the CVS Caremark business.