Category Archives: Investing Money

The Fiendish Bond Market Needs a Radical Rethink

My Comments: In keeping with my recent posts that suggest a strong market correction is coming soon, some readers have suggested the solution is to shift away from stocks into more bonds. I remind them that interest rates have been declining since 1981 and they too will reverse course at some point. When they do, you do not want to hold ANY long term bond positions.

The dilemma is that short term bonds have such lousy returns that they are almost meaningless. By the time you’ve paid taxes on the earnings, assuming they are not municipal bonds, and dealt with inflation, you have gone broke safely.

So this is an interesting read. Not sure it will or can happen. But if you are worried, we need to talk as there is a glimmer of hope that you can take advantage of.

Stephen Foley / October 29, 2014 4:42 pm

A trader works on the floor of the New York Stock Exchange minutes after a Federal Reserve announcement on January 29, 2014 in New York City. This was another Fed announcement of another reduction in its monthly bond buying program.

Shares in Verizon rose. Or they fell. Whichever, the point is that it is easy to keep track. The US telecoms group has one kind of share, whose price zips along the bottom of business news channel screens or pops up when you hover in FT.com stories. Would that it were so simple to keep track in the bond market.

Companies issue such a dizzying number of different bonds that it is impossible to focus the same light on the fixed income market as on equities. In the past, although bond investors grumbled, the opacity did not matter to companies one jot. But the market has changed and it matters now.

There are $7.7tn of corporate bonds outstanding in the US alone, financing business investment and economic growth (as well as, more recently, share buybacks that have plumped up equity markets). Fixing the market’s flaws is vital. It is time for a radical rethink of how companies issue debt.

Verizon, which holds the record for the most money raised on a single day in the bond market, has more than 70 kinds of bond out. When it sold $49bn of debt last year it did so in eight slices, each a different kind of bond paying a different interest rate and maturing on a different date. In the market last week, it raised another $6.5bn with bonds maturing in seven, 10 and 20 years. And Verizon is one of the more restrained issuers.

General Electric, whose shares are among the most widely held in the US, has more than 900 kinds of bond outstanding. Banks have even more: Citigroup had 1,865 separate types when Barclays counted them in April.

The inevitable result is that trading in any one bond issue is very thin, especially in those sold more than a year ago. Finding another investor who wants to buy the exact type of bond you are selling is no easy task at the best of times. If the end of quantitative easing marks the start of rising interest rates, which hurt bond prices, then investors’ 30-year love affair with fixed income may cool, and the market could become dicey indeed. Regulators worry about potential systemic risks in the event that sharp price falls in illiquid bond markets lead to big investor losses.

What is required is for corporate bonds to be standardised so that there are fewer of them trading more frequently. It is the principle adopted by the biggest debt issuer in the world – the US Treasury, which auctions new bonds on a strict timetable and whose 10-year Treasury note is the de facto benchmark for the fixed income market. The derivatives market, often described as the Wild West of the financial markets, is also highly uniform in parts.

Companies ought to increase the size of each individual bond issue to boost secondary market liquidity. They ought to adopt common interest payment dates. And they ought to issue debt on a regular timetable, perhaps quarterly for the biggest issuers, so that all bonds mature on the same dates. The easier it is for investors to make like-for-like comparisons, the more willing they will be to trade.

Corporate treasurers might ask what is in it for them. Right now they dip into the market opportunistically, trying to time it to catch the lowest possible borrowing costs. The trade-off is that standardised bonds that are more readily tradable by investors are likely to attract more demand, which itself will lower companies’ borrowing costs. Reducing complexity should also cut research and administration costs for borrower and bond investor alike.

Markets Up or Down Next Five Years?

global investingMy Comments: Here’s another cautionary tale to put somewhere in a mental box to look at when you start thinking again about your financial reserves. That another crash will happen is almost certain. What is not certain is when it will happen, so all you can do is decide whether you want help to figure out a solution before it happens or whether you are willing to do it yourself. Either way is OK.

My recommendation is to get several opinions to get an idea how people solved the last crash, or allowed their money to go down the tubes and had to simply wait for it to recover. I have a personal solution that I can share with you but this is not the forum to get into details.

MarkHulbert / Aug 26, 2014

CHAPEL HILL, N.C. (MarketWatch) — At some point in the next five years, the U.S. stock market is likely to be more than 30% lower than where it stands today.

That is the frightening conclusion in a recent study by Swiss economic and financial consultancy Wellershoff & Partners. The company, whose chief executive is former UBS chief economist Klaus Wellershof, found a strikingly strong inverse correlation between the stock market’s valuation and its maximum drawdown over the subsequent five years.

The reason this finding is such bad news for U.S. stocks: As judged by the cyclically adjusted P/E (CAPE) ratio that is championed by recent Nobel laureate Robert Shiller, the U.S. stock market’s current valuation is at one of its highest levels in history. The latest CAPE reading is 25.69, which is 61% higher than its historical median of 15.95 (and 55% higher than the historical mean of 16.55).

Wellershoff & Partners found that, since 1900, the average five-year decline following CAPE levels as high as current readings is between 30% and 35%. In contrast, when the CAPE has been below 15, its average drop over five years was below 10%.

Furthermore, the study found that there is little basis in the historical record for thinking the market will somehow be able to sidestep a big decrease during the next five years: “Going back to 1900, there has been only one instance when the valuation levels we see today were not followed by drawdowns of 15% or more over the subsequent five to six years. Thus, at least for the U.S. market, it seems fair to say that the risk of losing capital is substantial.”

To be sure, this recent study is not the first to point out the bearish implications of the above-average CAPE level in the U.S. But what is unique is that it focuses not on overall returns but on drawdowns. That’s important because long-term averages mask how volatile the market may be along the way, which, in turn, is related to how likely it is that we’ll bail out of stocks at some point in the next few years. The bailout point is usually at the point of maximum loss.

Imagine, for example, that the stock market will provide an inflation-adjusted return of 1% to 2% annualized over the next decade. That’s consistent with some analyses of what today’s high CAPE reading means. While that return is mediocre, it may still be high enough to convince you that it’s worth remaining invested in stocks, especially given the bleak outlook for long-term bonds.

But what if, on the way to producing that modest longer-term return, the market at some point plunges 35%? Many investors would find that loss intolerable and, therefore, bail out of stocks — which means they would not participate in any subsequent recovery that produces the net longer-term return of 1% to 2% annualized.

Note carefully that this study, by focusing on a drawdown that may occur at some point over the next five years, sheds no light on when it might occur. But if the study’s conclusions are right, the bulls are playing a very high-risk game.

Do you really want to play that game with your retirement assets?

Short-Term Optimism, Longer-Term Caution

profit-loss-riskMy Comments: You by now know that I’m expecting a signficant market correction in the near future. However, when I say that, one has to wonder what I mean by “near”. An analogy I sometimes use is a comment by a currency trader I knew years ago. His idea of “near” was in the next 24 hours; for him a long term hold has 3 or 4 days.

U.S. stocks will likely move higher as pension fund managers go bargain hunting in an effort to put seasonal cash inflows to work.

October 23, 2014 Commentary by Scott Minerd, Chairman of Investments and Global Chief Investment Officer, Guggenheim Investments

Last week’s investment roller coaster was something we had been expecting—U.S. stocks delivered their usual bout of seasonal volatility right on cue. For now, recent spread widening in high-yield bonds and leveraged bank loans seems to be over, and it also appears that equities have regained their footing after a turbulent week.

With the anticipated seasonal pattern of higher volatility in September and October now largely fulfilled, we anticipate more positive seasonal factors over the next two months. Over the last 68 years, the S&P 500 has averaged monthly gains of 0.9 percent in October, followed by even stronger increases of 1.2 percent in November and 1.8 percent in December.

The current dark cloud that hangs over Europe is a serious threat and something that investors should closely monitor. If the anticipated seasonal strength—which is typically driven by an influx of cash into pension funds that their managers are keen to put to work—is not forthcoming, investors should seriously question how much further the current bull market can run. As of now, we remain cautiously optimistic as we await some crucial economic data.

Economic Data Releases / U.S. Housing Market Data Is Solid

  • Existing home sales rose 2.4 percent in September to an annualized rate of 5.17 million homes, the highest in one year.
  • Housing starts rose 6.3 percent in September to an annualized pace of 1.02 million.
  • Most of the gains were driven by a 16.7 percent jump in multi-family starts.
  • Building permits increased by a modest 1.5 percent to 1.02 million in September.
  • The FHFA house price index rose a better-than-expected 0.5 percent in August, a five-month high.
  • University of Michigan Consumer Confidence rose to 86.4 from 84.6 in the initial October reading. The reading was the highest in seven years and was driven by better consumer expectations.
  • Initial jobless claims rose off a multi-year low for the week ending Oct. 18, increasing to 283,000, the fourth lowest reading this year.
  • The Leading Economic Index expanded by 0.8 percent in September. Nine of 10 indicators were positive.
  • The Consumer Price Index was unchanged on a year-over-year basis at 1.7 percent in September. The core CPI also remained at 1.7 percent. Falling energy prices were offset by higher food and shelter costs.

Stop Tinkering With Your Retirement Portfolio

InvestMy Comments: I can’t tell you how many times over the past 40 years that a client has talked with me suggesting something is wrong with his investments. It usually comes after a long run up in the markets and he or she thinks his portfolio is lagging. And almost every time we’ve made a change, it has resulted in something worse. We moved away from good stuff into bad stuff.

That’s not to say that changes should never be made. Some changes are for the best, like when you think the markets are likely to crash and you want some assurance that the manager you’ve chosen has the ability to move to cash when the you know what hits the fan. Most of them use the tactics described below.

My management team of choice these days will definitely miss some of the upside. But they will also miss most of the downside. That’s why they are my team of choice. If you want guarantees, you have to move your money to insurance company products, and for that you will pay a price in restricted access. But for some of your money, it’s very OK, as it allows the rest of your money to go with the flow.

By George Sisti, CFP (oncoursefp.com ) / Oct 9, 2014

Having just attended the annual convention of the Financial Planning Association, I think it’s appropriate to compare goal focused financial planning to the market focused, no-plan, portfolio tinkering strategy that most investors employ.

Good financial planning starts with the assumption that the future is uncertain, future rates of return are unpredictable and that diversification is the essential element of any prudent investment strategy.

Good financial planning takes time. Gathering and analyzing client data, discussing financial goals and developing a plan to attain them shouldn’t be rushed. An analysis of risk tolerance, insurance coverage, income, expenses and employee benefits should precede any portfolio allocation recommendations. Finally, clients should receive an Investment Policy Statement which summarizes what has been accomplished and explains the investment strategy being employed.

Upon completion of this process I am often asked, “How often will you look at my portfolio?” Many clients are bewildered when I answer, “As infrequently as possible.” The never ending babble coming from the financial media leads many investors to believe that their portfolios require constant tinkering. Most don’t realize that allowing their adviser to tinker with their portfolio will likely do more harm than good.

Perhaps it would sound more reassuring if I answered, “As often as I look at my own.” My portfolio consists solely of index exchange-traded funds, ETFs, and is designed to meet my financial goals at an acceptable level of expected volatility. Consequently, I never tinker with it and ponder its allocation only during its annual rebalancing.

You can control your portfolio’s inputs but not its performance; which will be determined primarily by its asset allocation. Its growth will be directly proportional to how well it was funded and inversely proportional to how much you tinkered with it. Like a good employee, it shouldn’t require continual oversight.

I can compare this to two automobiles I have owned — a 1974 Chevrolet Vega and a 2007 Acura. By 1978, the Vega was burning a quart of oil every 250 miles. I had my head under its hood every week to add oil or tinker with something that wasn’t working. Thankfully, those days are over. I’ve never opened the Acura’s hood. It runs flawlessly and has had no mechanical problems. About once a year, I take it to the dealer for service. He opens the hood and tinkers as required. I drive the car home and am content to keep the hood closed for another year.

Unless there are major changes in your personal circumstances, an annual portfolio review and rebalance should be sufficient. For the next 12 months you can concentrate on the more important and enjoyable things in life. Excess portfolio peeking leads to excess portfolio tinkering which inevitably leads to lower portfolio performance.

To many investors this sounds too simple, too good to be true. (It is simple, but it isn’t simplistic — there’s a difference.) Many believe that stock investing is a rigged game. Institutional money managers use elaborate software and powerful computers that constantly monitor a multitude of market indicators to generate buy and sell orders.

Misguided investors believe that they have to adopt similar strategies to level the playing field. But whether you count on your fingers or use sophisticated software, attempting to predict the market’s next move is a loser’s game — for both amateur and professional investors.

Instead of goals based financial planning, many financial advisers offer products and trading strategies that turn retirement investors into short-term speculators. This despite the fact that study after study shows that more frequent trading leads to lower returns. Too often the big winners in the “outsmart the market” game are, in John Bogle’s words, the croupiers in the Wall Street Casino.

Today, many investors are frightened and confused by the noise and conflicting advice emanating from the financial media. Consequently many are underfunding or poorly allocating their retirement accounts. A good financial plan containing a comprehensible investment strategy is the best defense against our natural tendency to make shortsighted, emotional investment decisions. Most financially secure retirees will admit that they rarely looked at their portfolios during their accumulation years.

Like it or not, most of us are our own pension plan managers. It’s a difficult task that few investors are capable of accomplishing without professional help. Unfortunately, this professional help is rarely client focused. Too often it is market focused and characterized by frequent portfolio tinkering based on forecasts of questionable value. It’s time for investors to say, “Enough already!”

You need a personal financial plan; one containing a comprehensible investment strategy that is based on your personal goals, not what the market did yesterday or what someone thinks it will do tomorrow. Take a pass on the continuing barrage of new products offered by the Wall Street Promise Machine.

Use low-cost index funds to create a diversified portfolio. By doing so, you’ll give less money to Wall Street’s asset eating dragon; you’ll have more working on your behalf and maximize your chances of attaining a comfortable retirement.

The 4 Drivers Of Stock Market Prices

profit-loss-riskMy Comments: In recent posts I’ve suggested there is a looming crash in the markets that will negatively impact all of us, except perhaps those of us with the ability to go to cash and go short when the crash happens. To hedge my comments, I’ve said “sometime in the next 3 years.”

Here is an article that suggests otherwise. If you don’t speak “economics”, this is relatively easy to follow and understand. Enjoy…

Greg Donaldson / Oct. 7, 2014

We have found that very few investors understand what really drives the stock market. In our view, the four primary drivers of market valuations are earnings, dividends, interest rates and inflation. If you can quantify what is going on with those four variables, our models indicate that you can predict about 90% of the annual movement of stock prices.

Last time, we talked about the Barnyard Forecast, which is a model that signals the probable direction of the market. While the Barnyard Forecast does correctly predict the market’s direction 6 to 18 months from now with about 80% accuracy, it is not a short-term predictor nor does it have any valuation component. Therefore, we use select valuation models to ascertain the relative attractiveness of stocks.

Almost all of these models use some component of the above mentioned variables. Within those four variables, there are two that stand out above the others as being the most important drivers. We’ll take a look at each factor and then conclude with what it means for stocks.

Earnings

Most investors look to earnings as the primary guide of what a company is worth. In theory, that makes sense. If Company A is earning $500 and Company B is earning $1,000 — wouldn’t you rather own Company B?

The problem with earnings is that they can be engineered by creative corporate executives. In times of recession, earnings are particularly volatile. Earnings can be calculated in a variety of different ways, which adds additional complexity. We don’t think earnings should be completely discounted in valuing companies or the stock market as a whole. However, the unpredictable nature of earnings often gives very bad signals at turning points in the market.

Dividends
We have found dividends to work much better than earnings. Over the past 50+ years, dividends have had approximately three times more predictive power than earnings.

Let’s say you own two rental properties. One rents for $100 per month and the other rents for $200. If both rents are increasing at 3% per year and both will continue to rent for the next 20 years, which rental property would be worth more to you? The one that will pay you the most in rental income over its useful life… right?

John Burr Williams was the first to apply this theory to stocks. He said the value of a stock today is the sum of all future dividend payments discounted back at some required rate of return. In other words, the more a company pays out to its owners in the future, the more valuable that company is to its owners today.

Not only does that theory make “real world” sense, but it also holds up statistically. In our models, we’ve found that dividends are the most important driver of stock prices by a wide margin.

Interest Rates
Interest rates are a primary concern for most stock investors. The general level of interest rates essentially represents the “opportunity cost” of investing in stocks.

If your bank account were to start offering 10% per year on your savings account, you would probably prefer to “invest” in your savings account rather than in the stock market. If your bank account is only paying 0.1%, however, the attractiveness of investing in stocks increases.

Many investors would be surprised, however, that interest rates are not the most important factor in determining long-term stock prices.

Inflation
Inflation is actually a much more significant predictor. How can that be? There are several reasons for this.
Interest rates can be artificially set by the Federal Reserve. Inflation can be influenced by Fed policy, however, it is primarily a result of real world economic activity.

Inflation is also one of the primary drivers of interest rates. If inflation is rising, it has the effect of diminishing the real rate of return for a bond investor. In that environment, a bond buyer will demand a higher rate of interest to compensate for the loss of purchasing power.

In addition, inflation is impacted to a large degree by economic growth. When the economy is growing at a faster rate, the Federal Reserve will generally tighten monetary policy, which raises interest rates.

The importance of inflation is also reflected in several of our models. We have a price-to-earnings (or “P/E”) Finder model that we use to determine the appropriate P/E ratio for stocks. In that model, inflation has been a much better predictor of P/E than interest rates, GDP growth or earnings growth expectations.

Outlook for Stocks
If you can understand these four variables, you can get a fairly accurate gauge of the valuation of the market. At this moment, all of these variables are very positive for stocks.

• Dividend growth for the S&P 500 has been over 10% year-to-date. We believe this will continue to be strong in 2015. Companies are beginning to understand how valuable their dividend checks are to shareholders and have begun to emphasize dividend growth as a priority.
• Earnings are expected to grow by over 10% in 2015. Time will tell whether that will come true or not. If it does, we anticipate the market will reward the companies for their continued strong performance.
• Inflation remains very low. With little capacity pressure from either employment or plant and equipment, we don’t see much of a chance that inflation gets higher than the Fed’s target of 2.5%. The economy is simply not growing fast enough.
• With inflation low and the Fed continuing their stimulative monetary policy, interest rates are likely to remain low. The 10-year Treasury continues to trade at the low end of our 2013 prediction of between 2.5% and 3.0%. We don’t anticipate that rates will get much higher than that over the near term.

As we talked about last week in our Barnyard Forecast, monetary policy conditions are very favorable. Aside from a major geopolitical shock, stocks don’t face any major red flags going into 2015.

The most current reading from our S&P 500 valuation model indicates that the fair value of the market is about 1,950. As this is being written, the S&P 500 is trading at about 1,952. From both a directional perspective and a valuation perspective, our models are saying that stocks are still the place to be.

Shoeshine Boys and Thinking At The Margin

My Comments: When the last crunch time came in 2008 and 2009, I vowed to find a better solution for my clients. The idea of losing 30% or more of the value of your retirement holdings over the course of a few months is devastating. For many, it’s taken years to get back to where they were.

What I found was an investment manager in Tacoma, Washington, that takes what is called a tactical approach to managing money rather than a strategic approach. The strategic approach still works for pension funds, insurance companies and foundations. They know they are in for the long haul, and that if they own good companies and safe bonds, if they are down today they will be up tomorrow. Only their tomorrow can be several years down the road.

For many of us, tomorrow is just that. Or perhaps next month or maybe next year. In the meantime we have to be able to sleep at night. This requires an approach to investing that allows us to be in cash overnight, with a possibility of going short if the signals tell us that a downward trend is upon us.

The dilemma I face as an advisor is that taking this approach means that you don’t capture all the upside, and clients are critical as they feel they are missing out on some of the historic upswing. I try to tell them it won’t last, but some of them don’t believe me. But I’ve been posting articles lately that suggest a reversal is soon to come. These comments by Joseph Calhoun bear me out. If you are worried about your circumstances, give me a call, and I’ll try and share with you what I think is likely to work in your favor.

Joseph Calhoun / Sep. 29, 2014

It is said that Joe Kennedy got out of the stock market in 1929 because he started to hear stock tips from his shoeshine boy. Bernard Baruch had similar feelings: When beggars and shoeshine boys, barbers and beauticians can tell you how to get rich it is time to remind yourself that there is no more dangerous illusion than the belief that one can get something for nothing.

What Baruch was pointing out was that the marginal buyer of stocks – the shoeshine boy – really didn’t know much about the markets and was most likely buying for reasons that had little to do with the underlying fundamentals. The shoeshine boy was buying because the market was going up and he saw it as an opportunity to get rich and stop shining the shoes of Bernard Baruch and Joe Kennedy. He was buying not because he believed the economy would perform well in the future or because he had some deep understanding of the fundamentals of the companies in which he was buying stock. He was buying because everyone else was doing it and getting rich and he wanted to claim his piece of the profits.

I have said many times that the economy is not the market and the market is not the economy. What I mean by that is that current stock prices are not just a reflection of the current economic data but also incorporate a view of the future economy. It is only in the future that you will find out whether that view of the future as captured in stock prices is correct. But whose view of the future economy? In 1929, for Bernard Baruch and Joe Kennedy, it was the marginal buyer, the shoeshine boy’s view of the future that was moving prices. And they were uncomfortable staking their fortunes on the views of the shoeshine boy or the barber or the beautician. So when I look at markets – any market – I always try to think through who the marginal buyer is, who is moving prices.

You don’t see shoeshine boys much anymore so we can’t just go down for a shine and ask him about his views on the market or the economy. But it is still possible, to some degree, to suss out who the marginal buyer is and judge whether you want to risk your capital on their opinion of the world. I remember reading an article in the Miami Herald in about 2006 that showed pictures of people camping out in a tropical storm for the chance to purchase a pre-construction condo.

Those were the people driving up the price of housing and that’s when I knew there was something seriously wrong with the housing market and that it probably wouldn’t end well. Normally rational people had seemingly lost their minds in pursuit of riches in the condo market.
They were the shoeshine boys.

I had similar feelings about stock buyers in the late ’90s when there were numerous articles about people quitting their day jobs to day trade full time. For me that brought back memories of an old trader who told me early in my career that one “shouldn’t bet the milk money on the markets.” Of course, just because the shoeshine boy is buying stocks that doesn’t mean that they are due for a fall. There may be a supply of shoeshine boys or day traders who have yet to commit their milk money to the market. It isn’t until the market runs out of shoeshine boys or to put it in the modern lexicon greater fools that the market will shift.

All markets are about the tug of war between bulls and bears and it is the marginal participant that makes the difference. If the market is in equilibrium and the bulls on one end of the rope can coax a bear to come over to their side, the market will rise. If a bull pulls a muscle, the market rope may move toward the bears. It doesn’t take all the bears or bulls to go to one side, only a sufficient number – enough at the margin – to tip the scales. And the rope will continue to move in the direction it is going until a sufficient number of rope pullers, bears or bulls, switch sides and a new equilibrium is reached at a new price.

I don’t think we are at the shoeshine boy level in the stock market just yet, but we do seem to be moving in that direction. The group on the sellers end of the rope over the last 18 months are private equity firms, venture capital firms and corporate insiders. The buyers end of the rope is populated by individuals, companies buying back their own stock and that of other companies (takeovers). The question you have to ask yourself is which team you want to be on; who do you want your teammates to be? The buyers have a poor long-term track record while the sellers are a pretty savvy group overall. Do you trust the companies buying back their own stock with company money or the insiders exchanging their own stock for cash? Whose view of the future is likely to be correct? The venture capital firms shoveling out IPOs at a pace second only to the peak of the dot com mania? Or the people scrambling to get in on the latest hot IPO with dreams of Alibaba riches in their heads?

We should also consider the divergent views of the bond and stock markets. The bond market shows high yield spreads widening, inflation and growth expectations falling and the long end of the yield curve flattening to levels last seen in the early months of 2009. That is a fairly bleak view of the future. The stock market would seem to be predicting the opposite, an acceleration in growth and profits that justifies paying above average multiples for stocks. It seems unlikely that both markets can be right but we don’t know yet which one has the correct view of the future. It may be that as the biggest marginal buyer of bonds – the Fed – stops buying that the bond market will shift to mirror the view of the stock market. But with the Fed reducing bond purchases all year and the bond market rising anyway, it appears there are still sufficient buyers at the margin to replace the demand of the Fed.

One warning sign for both stock and bond investors is the recent rise in volatility. It started first in the currency markets and is now starting to move to stocks and bonds. Volatility is essentially the opposite of liquidity so the rise in volatility is a warning that liquidity is drying up as the Fed ends QE. That is consistent with what we saw at the end of previous periods of QE and the view that tapering is indeed tightening and those trying to time the first rate hike are concentrating on the wrong thing. We won’t have to wait long to find out as the Fed will end their bond and mortgage purchasing next month.

Who will win the tug of war in the bond and stock markets? I don’t know of course since I can’t see the future. But like Bernard Baruch and Joe Kennedy, the marginal buyer of stocks right now makes me uncomfortable. Greed is the dominant theme of these buyers with FOMO (fear of missing out) driving their purchases. It may be that the bulls can continue to coax more bears to the bull side of the tug of war but the bear side of the rope is getting pretty thin. Did you ever see what happens when one side in a tug of war gives up?

For Safety and Yield, Where’s the Best Place to Park Cash?

Social Security 3My Comments: There’s an old adage in this business that “Cash is King”. You be the judge going forward.

By Adam Zoll | 09-16-14

Question: I’d like to invest a portion of my cash holdings in something safe that will earn at least a little interest. Between a money market account and a short-term bond fund, which is the better choice?

Answer: If you’re looking for a place to keep your money safe while still keeping it relatively liquid, money markets and short-term bond funds are good places to start. A certificate of deposit (CD) could also fill the bill; but assuming that you want to be able to access the funds without paying a penalty, a money market or short-term bond fund is a better choice.

Before we address the relative safety of each investment type, let’s take a look at their yields to determine where the best payouts are.

The Yield Question

Short-term bond funds currently yield around 1% on average, although some pay more than double that amount by taking on additional credit risk (more on that later). Money markets come in two flavors: money market accounts offered by banks and money market funds offered by mutual fund companies. Money market mutual funds pay just a measly 0.01% on average these days, and that’s often with fund companies subsidizing them (contributing extra money) to help keep their yields positive. Bank money market account yields are only slightly better at about 0.11% on average, according to Bankrate.com.

However, some banks–particularly online banks–offer money markets with yields that rival those of the average short-term bond fund. Some of these online money market accounts require minimum balances that may be prohibitive for some investors, and if you do decide to use one, make sure the rate you’re getting isn’t an introductory rate that will go away in a few months.

For investors who prefer to keep their liquid reserves under one roof or who are uncomfortable putting their money in an online bank, using a brick-and-mortar bank or fund company’s money market may be worth the lower yield for the added convenience. But before making a decision about which investment vehicle to use for your cash, make sure you understand the risks involved.

Not All Money Markets Work the Same Way
Bank and fund company money markets have some important differences. Among them is the fact that bank money market accounts typically are protected by the Federal Deposit Insurance Corporation, or FDIC, an independent agency of the federal government. That means that if the bank offering the money market goes out of business, investors can recoup up to $250,000 in lost funds.

Money market funds are not guaranteed by the FDIC, although they may be protected by SIPC, the Securities Investor Protection Corporation, if the fund company or brokerage is a member. (SIPC is a nonprofit corporation created by the federal government and funded by member financial institutions.) SIPC treats money market funds as securities, meaning they are subject to a $500,000 guarantee if the fund company or brokerage offering them fails.

Most importantly, while bank money market accounts are guaranteed not to lose value, the same cannot be said of money market funds offered by fund companies.

Historically, fund companies have used a net asset value of $1 per share for their money market funds, and only rarely has the performance of the fund’s underlying holdings caused this to waver. However, during the financial crisis in 2008, one money market fund, Reserve Primary Fund, “broke the buck,” meaning that the net asset value of its shares fell below the $1-per-share standard after Lehman Brothers debt securities held in its portfolio lost value. The federal government stepped in to temporarily guarantee that investors in all money market funds would not lose money; but in the aftermath of that event, the SEC began taking a long, hard look at money market mutual funds and, in particular, the question of whether fund companies should be allowed to “artificially” maintain the $1-per-share standard by adding assets to a money market fund when its underlying holdings lose value. In July of this year, the SEC finally issued new rules that require money market funds for institutional investors to have a floating net asset value–in other words, to accurately reflect the value of the underlying holdings–though, money market funds for retail investors aren’t affected.

Short-Term Bond Funds: Maybe Not So Low-Risk After All

Short-term and ultrashort bond funds have something in common with money market mutual funds in that all three invest in short-term fixed-income securities. However, while a money market mutual fund might own very short-term securities with maturities of 60 days or so, short-term and ultrashort bond funds typically own bonds with maturities that are somewhat longer.

Morningstar defines ultrashort bond funds as those investing in bonds with durations of less than one year and short-term bond funds as those investing in bonds with durations of between 1 and 3.5 years. (Duration is a measure of interest-rate sensitivity based partly on the bond’s maturity.)

Because they invest in bonds with longer maturities than those used by money market funds, short-term bond funds, in particular, are more subject to interest-rate risk. After all, if rates rise, the value of a 60-day bond will be less affected than the value of a 3-year bond. That’s because when interest rates rise, the value of existing bonds drops to make the lower yields they pay more attractive to investors. For bonds with longer maturities, this effect is more pronounced than for bonds with shorter maturities.

But that’s not the only potential risk factor present with short-term bond funds. Morningstar senior fund analyst Eric Jacobson says credit risk is another. “A handful of short-term bond funds have notably large allocations to mid- and lower-quality bonds,” he says. “Most investors tend to use this category as a place to find funds for the most conservative allocations of their portfolios. As such, it’s extremely important to recognize that while none of the funds in the [short-term bond] category breach our rules to the point of warranting a change to another category, several are close, and an even larger number of funds in the group have taken on meaningful credit risk.”

It’s worth noting that in 2008, when the financial crisis raged and investors fled credit-sensitive bonds, the average short-term bond fund lost 4.2%. And while the ultrashort bond category didn’t exist back then, Christine Benz, Morningstar’s director of personal finance, writes here that some ultrashort bond funds dip into lower-quality issues as well. Money market funds, on the other hand, are restricted from owning below-investment-grade securities, meaning that there is much less risk of default on the securities they own.

The Takeaway

For a combination of safety and yield, an FDIC-insured online bank money market account may be your best bet, at least for now. That could change if and when interest rates rise if such an increase would allow short-term bond funds to begin paying yields that are significantly higher than money market yields. But given today’s choice between a guaranteed rate of close to 1% and a nonguaranteed rate that’s not much higher, you’re probably better off with the former.