Crowded Trades

August 2, 2016 Gil Baumgarten

Economics is the place where politics, finance, and personal priorities collide. It is the study of us doing what we have an incentive to do. These forces don't often work in unison; more likely in opposition. Equilibrium is maintained in these opposing forces, and the gaining momentum of one factor normally comes at the cost of the other factors. Understanding this can make for better investment choices. But please don't confuse politics as the force for good.

Over the past decade many clients have argued their rationale for wanting shorter term bonds in light of low interest rates. All the while listening to me say that even lower rates were the risk, not higher rates. Their position is understandable, given how ugly the late 70s were on bond holdings while interest rates skyrocketed. We have an innate fear of reliving that. Yet, I believe those lower-rate-forces are still in play today. However, we see some bumps coming that appear likely to temporarily upset those standing in the crowd on one side of the ship.

Segment Wealth Management Blog Investors are starved for cash flow

There is only one mantra today: I'm nervous and I want yield, yield, yield. Investors are starved for cash flow, and they will buy anything that promises it, especially if it comes from traditional "low-beta" bets like utility stocks. Investors are clearly lined up at the railing of the ship on that bet. We foresee a bump in the road that will send folks scattering. When they do, you should take their spot, because the bump won't last.

Be sure of one thing, if an investment pays a higher cash flow, there's a reason for it. The owner of the cash being paid to you as an investor never does so out of benevolence. They only pay what is required to attract capital. If the risk is outstripped by the return because the price is too low, the price of the investment will rise until the risk matches the new lower return. When safer alternatives rise in yield, investors will switch horses.

Utility stocks act much like a bond; performing well when interest rates are stable to lower, and performing poorly when rates rise. This is because fickle investors will swap for the safer bond if cash flow is similar. Utility stocks were one of the worst performers in 2015 when the Fed had everyone convinced they would hike rates. When investors realized the Fed was again simply joking, they piled back in. We took huge profits in utilities last year, only to immediately buy them back when the Fed's head fake had passed. Utilities are up roughly another 20% again this year, and it's only July! We don't see that as being sustainable and we think the Fed is more serious this time with their threats to hike rates. We have again reduced our holdings of utility stocks over the past week or so accordingly.

Segment Wealth Management Blog election time.png

Our rationale is that the "buy-utilities" trade is crowded, and the Fed can only bluff about hiking rates for so long before they become a laughingstock. They have jawboned about raising rates since 2009, but have only done so once. The rest of the time they explain why the timing is not right. Additionally, you may have noticed that during the past several years in particular, non-political portions of our government have become decidedly political. Recent inappropriate remarks from a certain Supreme Court Justice arguing the merits and flaws of current presidential candidates is a prime example of the politicization of these bodies. The Fed is another, offering economic guidance in concert with the Administration. Accordingly, I think you can expect the rhetoric on rate hikes to heat up again before the election. This will be used to confirm "our sound footing" in an effort to maintain the status quo come election time. I figure it will be a one-time event, driven by politics and not economics. That should spark fear among investors that the long awaited return to "normal" is imminent. Not so fast. This lower rate trend will likely still be intact, but just suffering a short term setback due to political jockeying while still lacking long term impetus. But the shudders will seem real at the time. The likely resulting wind shear in prices will create a great entry point for the next leg down in rates while dodging the oncoming indigestion for those who took the reprieve.

The election will create a host of new opportunities and risks, but I don't believe interest rate policy will be among them, at least at first. My peek around the corner to that topic will be in my next blog post where we will explore defense spending, and the impact of a possible regime change.