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Mid Year Update- May 2015

 

I thought I would provide a mid year update, and summarize a few trends.

 

The market has been mostly treading water for the year so far, but in the main, the income machines keep producing for you. The big shock to some portfolios before the New Year was the death spiral in the price of oil, which managed to rebound somewhat. The retracement presented an opportunity to bail on some issues we had held for quite some time. Someone on social media had posted a picture of an excerpt from the Chartered Financial Analyst's training textbook which stated that “oil related equities were reliable sources of consistent income.“ The joke is that someone will have to rip out that page.

 

The oil rout was hard to understand or predict. Since I follow the energy space, both fossil and non, it was clear that new domestic supplies, combined with declining consumption, should have had some effect on pricing, but yet, prices remained “sticky” for years, and as I've mentioned in prior year end summaries, the market trades with a heavy dose of leverage, and would react violently to even minor events, like an attack on a single pipeline in some obscure part of the world. But to plummet from a price of $106.06 on July 1, 2014, to free fall down to $44.80 by January 6 in the following year, as if all of the years of new supply and the steady decline in consumption became somehow compressed, and factored into the price in such a short time, tells you a lot about how markets work, and sometimes, DON'T work. Again, the unwinding of leverage positions exacerbated the move, so some retracement was expected, but one thing is clear: this sector is no longer the steady cash cow it had been for years, and that is indeed a shame, because we've made good use of it. Even if supply is manipulated downwards, the onslaught of new technologies and efficiencies will likely suppress prices. If you follow the alternative energy space, you'll know just how fast this is happening. We are hurtling towards a whole new energy supply and consumption paradigm. Be prepared to be amazed. Once again, a key segment of the global economy is being remade.

 

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The market anticipates a rate hike with the same fear it would for say, a near miss by an oncoming asteroid. To paraphrase Winston Churchill, “never have so many, feared so much, for so long, for so few basis points.” It's not really the ¼ point launch that's the issue here, though. What the market really fears is a break in a six year trend, and the first thing the market will worry about after the first hike will be the next one. But I curse the financial media for stoking the fear. Any lull in the flow of corporate earnings or genuine economic news means that rate speculation is used as “filler.” I'm getting quite sick of hearing it, because even the Fed itself probably hasn't set the exact timing yet. They will do what they have to do when they have to do it. But it seems that every time we near a point of critical mass, where a rate rise is warranted, either the economy or commodity prices sag, or the dollar surges, making the Fed look like Charlie Brown after Lucy has pulled the football away. A great many observers placed their money on a June hike, and for what seems the umpteenth time, were forced to re-calibrate their expectations.

 

Just to be clear on a point many have missed about Fed operations, “QE3” has ended, but only in the respect that the Fed has stopped adding to it's positions. When their mortgage paper rolls off, for example, (something you CMO holders know all about) they go out in the market and replace it. I actually sent an e-mail to a Fed Governor asking them why don't they let their mortgage debt roll off naturally as a way to normalize the debt markets. There's less drama than an outright rate hike, and the market is still hungry for the supply. Maybe they listened to me: this Fall, they will allow mortgage debt to roll off, but will continue to maintain their Treasury supply. I'm not taking credit, but never doubt the power of communication in today's connected world. Even a single tweet can start a trend.

 

 

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With some rare exceptions (i.e., where there was some value offered,) corporate and muni bonds were avoided. As I've mentioned before, there is simply too much “yield compression” in the market, and I am somewhat fearful of bond prices unwinding in our faces like a broken mainspring. (I do hope my younger investors know what a “mainspring” is.) In the muni space, refundings, that is, maturing bonds rolled over into new ones with lower coupons, made up for an astounding 70% of the new issue market. Despite our infrastructure needs, bond market observers are confounded by the reticence of local governments to issue paper at what are the cheapest borrowing costs of a generation, and many of these projects DO pay back handsomely, not only in the immediate stimulus of job creation and construction materials, but for decades to come in service. When new issues came to market, they were heavily oversubscribed, which had to benefit the issuers even more than they had hoped.

 

On the corporate side, there has been ample use of low rates, but many times not for the right reasons. Some firms monetized their overseas cash hordes with U.S. issued debt to facilitate stock buy backs. I could think of more effective uses of capital in a world filled with real needs. In addition, the issuers have free reign to issue what is known as “covenant light” debt, meaning we have probably seen the last of paper with “make whole” provisions, triggered protections, and prospectuses now have to be combed for “gotcha” clauses, or worse, covenants that have ceased to exist. When bonds are oversubscribed, issuers have no incentive to strengthen covenants, because they know the market will take what it can get.

 

This is one of the advantages of dealing with a firm that can go anywhere in the market to get yield. While we patiently wait for equilibrium to return to traditional Fixed Income markets, we'll let the others take the risks with low rewards in these arenas. I look at the meager coupons of some of the lousiest credits you can imagine, and ask myself who is buying this stuff?

 

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On the regulatory front, there has actually been some meaningful change. With the more effective Mary Jo White replacing the execrable, appalling, strictly from hunger Mary Schapiro at the SEC, the fiduciary standard may wind up applying to everyone who sells securities, including commissioned brokers. This, folks, is new. Originally proposed by the Department of Labor, it's freaking the brokerage community out, because it practically mandates a change in the broker/dealer/wirehouse culture. Once implemented, a broker will have to offer products that are in YOUR best interests, not theirs, and while there are good brokers out there who do this, they were still held to a vague “suitability” standard, which meant they could sell you a product that paid them more in commission so long as it was “suitable” for your risk profile. Whether the product was better or not was secondary. Not any more. The industry flew into panic mode and threw millions at lobbyists and Congress to stop this. But with the President, the head of the SEC, and even the thoroughly corrupted FINRA backing the DOL's measure (they have since backed down from their support, no doubt getting an earful from the ones they "regulate") the momentum may not be stopped. Stay tuned. How did this wind up being a Department of Labor mandate? Simple: since 401(k)s and most other plans covered by ERISA fall under the fiduciary mandate, they reasoned that protection shouldn't be lost once the plan funds were rolled over into an IRA. And they're right.

 

 

The other big news was a 9-0 ruling by the Supreme Court which ruled, and I quote, “Fiduciaries can’t put decisions on investments on autopilot,” which is something yours truly has been railing about for over a decade. I had a client who spent her working life at the old Long Island Jewish Hospital, when it was just the lone building in New Hyde Park. Her 401(k) funds were picked at the time of her vesting, and had not changed for decades, nor had the firm that “managed “ the plan (and must have made fantastic sums from) ever contacted her to adjust her holdings. I've gotten into on-line flame wars calling these people out for the charlatans they are. Basically, they're asset gatherers. They take over the plan, then tell Ethel the receptionist to pick out some funds, and they're never seen or heard from again. And then they collect for doing absolutely nothing, getting the rake off from the mutual fund families that pay them the most on the back end. It's a national disgrace, but finally, the law is catching up with them. The implementation of a single fiduciary standard, and holding fiduciaries responsible for proper management, is a meaningful change for the investing public, and they deserve it. This reaffirms a key ethic of fiduciary law that had been all but forgotten: the Duty of Loyalty. That has a nice ring to it.

 

I always have too much to say, so I'll end it here, and simply wish everyone all the best for a great summer.

To My Clients and Friends:

FloMartin Securities, Inc.

Donald R. Davret, Investment Advisor Representative

www.sec.gov

www.sipc.org

 

Investment advisory services are offered through FloMartin Securities, Inc, an Investment Advisory firm. The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements.
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