Investment Themes

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Municipal Bonds: Hooked on Tobacco

Rising Inflation? That’s For Time To Decide

The Power of Blind Luck

But Will They Return?

Risk On, Risk On

Municipal Bonds: Hooked on Tobacco

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J.R. Rieger

Head of Fixed Income Indices

S&P Dow Jones Indices

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The S&P Municipal Bond Tobacco Index has returned 12.79% year to date as the tobacco settlement bond market has recovered from a dismal 2013 return of -8.77%. Yields of these bonds have fallen 99bps during the year to an average of 5.92%. These long duration higher yielding bonds represent just under 15% of the total market value of the S&P Municipal Bond High Yield Index which has returned 9.86% year to date.

Yield investors seem to be willing to accept significant incremental risk over the near term as the prospects for repayment of tobacco settlement bonds is dependent upon tobacco sales in the U.S. which has been declining over time and may be a critical factor that may drive defaults of these bonds in the future.

The ten year range of the municipal bond market remains relatively cheap given the S&P AMT-Free Municipal Series 2023 Index has an average tax free yield of 2.53% which is just 5bps below the 10 year U.S. Treasury Bond.

Longer, high quality municipal bonds tracked in the S&P Municipal Bond 20 Year High Grade Index have returned over 12.2% year to date as yields have dropped by 79bps during the year so far.

Returns of Select Municipal Bond Indices as of June 12, 2014:Source: S&P Dow Jones Indices.  Data as of June 12, 2014.

Source: S&P Dow Jones Indices. Data as of June 12, 2014.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Rising Inflation? That’s For Time To Decide

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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With the volume of news headlines and the speed of information, tid bits of news, some with the potential to be significant, can naturally get lost in the shuffle. One such issue that might have some significance in the coming weeks is the president of the St. Louis Federal Reserve, James Bullard saying that there is evidence of inflation “moving higher”. This statement shows a change in Bullard’s view point. In the past, he has shown concern over the low levels of inflation and recently has commented on the stability of the inflation rate. As of April 30, the level of annual inflation is 2%.

The Consumer Price Index (CPI) is a widely recognized price measure used in the U.S. to track the price of a market basket of goods and services purchased by individuals. The weights of the components are based on consumer spending patterns. The next release of the CPI will be June 17 and the market’s survey is calling for a month-over-month value of 0.2%. The CPI value has been trending higher since February’s 0.10% as March and April were 0.2% and 0.26%, respectively.

Rising inflation expectations resulting from comments in the news and recent CPI results can be attibuted to the performance of Treasury Inflation Protections Securities (TIPS). The S&P U.S. TIPS Index, a broad, comprehensive, market value-weighted index seeks to measure the performance of the U.S. TIPS market. Year-to-date, the index is returning 5.37%. Longer maturity indices such as the S&P 15+ Year U.S. Treasury TIPS Index returned 16.64% (see table).

The last TIPS auction was May 28 an $13 billion of a reopened 10-year TIPS was issued. The initial market reaction to the auction was positive. Since May 28, the return of the 10-year TIPS has been +0.62% as measured by the S&P 10 Year U.S. TIPS Index. The next auction for 30-year TIPS will be on June 19th, a reopening of the existing 29-year, 8-month 1.375% of Feb. 2044, and the amount offered will be $7 billion.

Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment of similar maturity and credit quality. If inflation averages more than the break-even, the inflation-linked investment will outperform the fixed-rate. Conversely, if inflation averages below the break-even, the fixed-rate will outperform the inflation-linked. Presently the break-even inflation of the 10-year TIPS is at 2.40%. This means that if inflation averages more than 2.40% over the next 10 years, TIPS will outperform a traditional Treasury. Time will tell if the rate at which inflation is rising in the U.S. could become a problem for the Federal Reserve or investors.
Break-Even InflationSource: S&P Dow Jones Indices, June 11, 2014
Note: Though both indices measure 10 years they have not been duration matched.

TIPS Total Return Performance

 

 

 

 

 

 

 

 

 

 

 

 

 

Source: S&P Dow Jones Indices, June 11, 2014

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

The Power of Blind Luck

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

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This is a story about the power of randomness, and its application to investing.

A good few years ago, I had the pleasure of meeting Bob “The Rock” Cooper. Bob, an otherwise unassuming sales manager from London, had just won the world championship in the princely sport of “Rock Paper Scissors”. Yes, there is such a thing.

At the time I met Bob, I was working for the Royal Institution of Great Britain, which has hosted a series of “Christmas Lectures” presenting scientific concepts to a young audience every year since 1825, barring a brief interlude during the Second World War.

In 2006, the topic of the lectures was mathematics.1  As one of the lectures was based on probability; we invited Bob in to talk about game theory, randomness and to try and beat him at Rock Paper Scissors.

Now, Bob’s pretty good at reading people’s intentions. He knows a good deal of behavioral psychology, and he plays a lot of Rock Paper Scissors. Unless you know as much as he does, whatever your strategy is, he’s going to beat you. He certainly could beat an 11-year old kid.

How do you beat Bob? You can’t determine a winning strategy, but you can improve your odds. If you play at random, you have a 50% chance of winning.  That’s as good a chance of beating him as he has of beating you – you’ve levelled the playing field.

What does this have to do with investing? Well, actually quite a lot. Think of the markets as Bob. They’re smarter than you, they’re good at exploiting your intentions, and if you try to beat them, on average you’re likely to fail. But if you play at random, you can improve your odds, potentially by a considerable margin.

Of course, I’m not recommending that investors should pick their investments at random. What we do recommend, however, is that investors keep an eye on the performance of equal weight indices. They tell you the performance of a random investment strategy. That’s convenient in terms of benchmarking: any “alpha” strategy worth its salt should outperform in comparison. Not many do.


 

  1. If you’re interested, the full series is available here – although please be warned that the target audience is young children.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

But Will They Return?

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Howard Silverblatt

Senior Index Analyst, Product Management

S&P Dow Jones Indices

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The key bar-room conversation this week has not been the stock market highs, or concern over elevated P/Es, or when a correction might arrive (the last one being in 2011 for big-caps), or even the increased M&A premiums being paid. It was stock splits, inspired by Apple’s 7-for-1 and the recollection, for those who have been on the Street for a few decades or more, and those newcomers who listened in, that in the 80s and prior, stock splits were money makers. Back then you actually paid cash for a service that sent a message (pre-twitter) to your beeper that a company had announced a planned split – and you would then purchase the stock – because it would go up (most likely).

The situation back then was that companies liked to keep their stock in a comfort zone, say $50 (for illustration), where investors felt comfortable buying and holding it. Additionally, old lots were inefficient in price and high in commissions (commissions were de-regulated in 1975, when brokerage consolidation slowly started and regulatory review was very show and long). Companies liked a broad base of individuals, which many felt gave support to the company; as compared to institutions which could be difficult (to put it nicely), or down-right unfriendly (Gulf & Devour). So when a stock reached a certain level, the company would split it, returning it to the comfort level (note: if $50 was the desired level, a 2-for-1 would most likely take place at $110 or higher, giving the company some protection in case the stock experienced a downdraft after the split – either because of company events or just market conditions). That thought process declined as quick trades came in along with the concept of capital appreciation only. Higher priced stocks were also becoming more acceptable, and the ability to purchase a dollar amount was made easier via brokerage consolidation, discount houses, and of course – the internet. Once we got past Y2K two recessions kept splits at bay (with the market sometimes splitting your stock in price, even though you did not get the extra shares).

Which brings us to Apple’s 7-for-1. There are many reasons why Apple split, but many believe it was to make its stock price, which was $646 per share before the split and $94 now, more attractive to individual investors, and broaden its investor base. Some even joked about a rebate program – buy a full-priced iPhone and get a share (not sure how that would work with disclosure or compliance). Also accepted was the idea that a border individual investor base could insulate the company from institutions and activists, who have been a bit more busy as company assets (especially cash) have grown. So, the question is – IF, yes IF, the lower price brings in more individuals (which would also add to buying and support the stock), and ‘assists’ with ‘dealing’ with certain holders, will more companies do it? Don’t know the answer, but as the Fed told the banks – I’ll be watching you.

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And while we all know that June is the most popular wedding month, it also appears to be the most popular split month (don’t know about divorces – still happy with my first)

 Recent Splits:

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The posts on this blog are opinions, not advice. Please read our Disclaimers.

Risk On, Risk On

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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Central banks do more than set interest rates in an attempt to guide the economy. They also push and prod market psychology to move the economy in the direction they think best. Easy money and low interest rates send messages to take risks, spend money, boost a slow economy and be confident that the central bank might help out. Tight money and rising interest rates send the reverse messages: be wary, pull back, don’t over heat the economy, don’t push prices up. This game of market psychology has been nick-named Risk On-Risk off.

The game isn’t new.  It dates at least back to a Scottish economist, John Law (1671-1729) who defied the reputation that the Scots are skillful at managing money when he introduced a version of central banking to France with disastrous results.  It was all Risk On, but Law managed to evade the consequences for a time.  A more modern analysis comes from another economist, Hyman Minsky (1919-1996).  Minsky’s saw economic growth, rising securities prices and government support and bailouts as encouraging optimism and risk taking.  As the good times roll, markets forget their fears.  Forgetfulness leads to Risk On all the time. The Great Moderation (1982-20070 of rising stock and bond prices, low unemployment and low inflation set the stage for the financial crisis.  Banks became leveraged to the extreme and people borrowed money with no idea of how they would repay the debts.  The result was the financial crisis of 2007-8.

We may have too much Risk On optimism and not enough Risk Off fear today.  As widely noted, volatility is very low, VIX seems stuck in the basement and similar volatility measures for non-US equity markets, oil and other investments are similarly low.  Stock prices keep rising, defying both the skeptics and the bears.  Common sense suggests that VIX can’t fall and the S&P 500 and the Dow can’t rise forever — but experience keeps challenging this. Herbert Stein, another economist, commented, “If something can’t go one forever, sooner or later it will end.”

How will it end?  Certainly no one knows either the How or the When.  The S&P 500 could sail through 2000 to 2500 or beyond or collapse as it did twice in this young century.   Out of the infinite possibilities consider two:

A collapse and sharp drop cannot be ruled out.  Some of the tech stock stories heard today are eerie echoes of March 2000.  Technology is again the largest sector in the S&P 500, but far below the third of the total index seen some 14 years ago. Moreover, the index itself is less top heavy than it was then.

Things could crumble.  The Fed has hinted that sooner or later it will raise interest rates and a minority on the FOMC is leaning in that direction.  In just about every major reversal of Fed policy, analysts knew it was coming but were surprised (shocked?) when it happened.   When the Fed raises interest rates, markets are likely to drop. It could be a bigger bang than the tapering announcement in May 2013.

While the Fed’s monetary policy since 2009 has been largely successful,  no one will argue for perfection.  The same is true of its ability to guide market psychology.

The posts on this blog are opinions, not advice. Please read our Disclaimers.