Jim Kopas

The 2007-2009 global financial panic and collapse provided investors with a once in a lifetime rollercoaster ride as all asset classes except for treasury bonds dropped to extreme lows. A vast spectrum of emotions accompanied investors on this thrill-ride and not surprisingly many of these emotions are shaping investors current investment decisions.

In search for safety and income investors are stampeding into the apparent safety of government bonds and bond mutual funds. Over the last year bonds have been purchased in record amounts despite historic low interest rate levels.  It is likely that many of these investors do not understand the risks in bonds.  These investors, with a false sense of security, are unknowingly setting themselves up for another rough rollercoaster ride ahead.  

Warning Sign: High Level of Flows to Bond Funds

Despite the remarkable rally in stocks over the last nine months the distrust in equity markets is still widespread.  The cash flow figures into bond mutual funds this year illustrate this point (see chart below) as almost $313 billion has been invested in bond funds compared to the $2 billion added to stock funds through October. In addition, insignificant yields on money market funds are testing investor’s patience and are yet another reason for the remarkable cash flow into bonds.    

History shows that cash flows to mutual funds tend to follow strong outperformance by a particular asset class and can provide a contrarian warning sign when a particular class is becoming too popular.  For example, in 1999-2000, the cash flow to mutual funds was a mirror image of today’s environment as investors were taking money out of bond funds to invest in stock funds. The dilemma that many investors face today is that they are too afraid to invest in stocks and too impatient to wait for money market yields to increase. Unfortunately these investors are settling for bonds without fully understanding the risks involved.

The Risk in Bonds

The biggest risk bond investor’s face is the potential for interest rates to rise.  Bond prices move inversely with interest rates (as interest rates rise bond prices fall and as interest rates fall bond prices rise).  In addition, the lower the coupon rate of a bond the more vulnerable it is to interest rate risk.  With interest rates at historic low levels and likely to rise in the year ahead, now more then ever, bonds are highly susceptible to interest rate risk. 

The chart above demonstrates how higher interest rates can effect the value of a 10-Year U.S. Treasury Note.  The chart answers the question: how much will a $100,000 investment in treasury notes be worth in one year?  The value of the note depends on the future interest rate. For example, an investor’s initial $100,000 purchase would drop in value to $89,479 in one year if interest rates simply recovered to the June 2007 level of 5.3%.  If investors choose to invest in bonds with longer maturities then the negative returns due to interest rate risk will be amplified.  This chart clearly shows the potential loss of principal due to modest interest rate increases that would eliminate any potential gains from coupon payments.              

What Can Bond Investors Do?

The premise of this post is not to convince bond investors to liquidate all holdings, but to alert them to change their investment tactics. Bonds are a vital element of investment success as they provide diversification which can significantly temper the risks of an investment portfolio. However, it is critical that investors stick to bonds with short term maturities and not over-emphasize long term bonds at this time.  

Today’s low level of interest rates is only a temporary condition of this business cycle.  Interest rates will continue to move up as the economy picks up steam, offering patient investors a better opportunity to receive higher levels of income from bonds. Our business cycle research at Pring Turner Capital Group indicates it is very late and too risky to be pouring money into bonds.  Potential losses in principal value will quickly swamp any income received as interest rates inevitably move up and bond prices decline.

As always, thanks for reading and please feel free to voice your opinions in the comments section below. I hope you all have a Happy and Safe New Year! -Jim

Jim Kopas Investments

The 2007-2009 global financial crisis, the second most vicious bear market of the last century, caught many off guard and displayed unexpected characteristics when compared to past economic downturns.  With the decline being so atypical many are surprised to learn that the road to recovery has been just the opposite, as the economy has mirrored the typical business cycle recovery. 

In simplified terms, the sequence of events for a business recovery is first the stock market bottoms (March 2009).  Then the recession ends several months later (June/July 2009).  Next, the unemployment rate continues higher long after the recession ends, until economic expansion eventually brings job growth.  Finally, some time after unemployment peaks, the official end of the recession is announced – long after the stock market has bottomed (see table below).  Now the next logical step in the business cycle sequence is to see job growth and a peak in unemployment.  So when can we expect more jobs and how many will be created?

 When Will Jobs Rebound?

In recent weeks, some positive developments in the labor market have emerged amid the discouraging news about the climbing unemployment rate.  In November, the average workweek bounced to 33.2 hours from 33.0, which represents the biggest monthly rise since March 2003.  This is a strong precursor for the job market as business owners will typically ask current employees to work more hours prior to hiring new employees.  Ned Davis Research estimates that “the rise in the average workweek is roughly the equivalent of creating another 800,000 jobs!”

Another positive indication for the labor market is the recent growth of temporary employees. Temporary employees are the first to be let off in economic downturns and the first to be re-hired during expansions. Through October and November the number of temporary employment positions increased by 44,000 and 52,000 respectively.  Initial jobless claims represent yet another indicator for the future prospects of the job market.  The initial jobless claims 4-week moving average currently resides around 475,000.  Economists believe that job growth will occur should the average continue down below the 400,000 mark. 

Even as the unemployment rate continues to rise we are seeing some positive indications within the economy that should lead to job growth in the near future.  Former Federal Reserve Chairman Alan Greenspan echoes this sentiment, “We have a level of employment at this stage which is barely adequate to staff the level of output.  It seems to me virtually inevitable – if nothing else were to happen – that employment would start to come back fairly quickly.” So we are on the verge of experiencing job growth, but just how much job growth is the important question?  

How Many Jobs Will be Created?

At the cost of stating the obvious, jobs are highly correlated with the growth of the economy. Quite simply, the higher the economic growth rate is over the next year, the larger the increase in jobs and decrease in the unemployment rate.  A recent blog post on calculatedriskblog.com titled, “Employment and Real GDP” forecasts the expected unemployment rates under varying economic scenarios.

According to their data, “A 3% increase in real GDP (over the next year) would lead to about a 1.5% increase in payroll employment.  With approximately 131 million payroll jobs, a 1.5% increase in payroll employment would be just under 2 million jobs over the next year – and the unemployment rate would probably remain close to 10%.”  The table below summarizes the wide range of economic and job growth scenarios.

In my opinion the global financial crisis and rapid deterioration of the U.S. economy frightened business managers so terribly that they cut their payrolls more swiftly then they had in the past. Therefore, the payroll growth provided in the model and table could be understated.  Nevertheless, this forecast provides us with a general understanding of the relationship between the economy and the labor market. It certainly appears that the U.S. economy is well on its way to creating new jobs and taking its next step in this business cycle recovery.

As always, I look forward to hearing your opinions so please feel free to add a comment below.

–Jim   

Jim Kopas Economy

In recent weeks the growing unemployment rate has garnered a great deal of attention from members of the financial press in addition to stock market investors. In an attempt to ease the collective nerves of these individuals I published an article “10% unemployment: A Remarkable Signal for Stocks,” which revealed that over the last 40 years the stock market has performed exceptionally well after unemployment has peaked.

Unfortunately, my article failed to touch on the performance of the stock market prior to the peak in unemployment.  With unemployment still on the rise some readers had doubts about the near term prospects of the stock market. So how has the stock market performed prior to the peak in unemployment? Surprisingly stocks are more profitable prior to peaks in unemployment then they are after!

Stock Market Performance Prior to Peaks in Unemployment

Many will be shocked to learn that the stock market has actually performed better right before the peak in unemployment the then it has right after the peak.  As illustrated in the table below, the short term time frames before the peak in unemployment all substantially outperform the periods after the peak. Contrary to popular belief, there is actually a lower risk for stocks near unemployment rate peaks (indicated by the green arrows) then there is during unemployment lows (indicated by the orange arrows).

Why does the Stock Market Perform Better Prior to the Unemployment Peak?

On several occasions I have mentioned leading, coincident, and lagging indicators; and their ability to help anticipate changes in financial markets and the economy (see 3 Crucial Economic Indicators).  The key reason why stocks yield strong returns prior to the peak in unemployment is because unemployment is a lagging economic indicator and will only start to improve months after the stock market (leading indicator) and economy (coincident indicator) have recovered. In fact, if you analyze all the economic data since WWII unemployment peaks (on average) 9-12 months after the stock market bottoms.    

Now let us take a look at how these economic indicators relate to the current financial landscape.  In the beginning of the year the Fed dropped their target rate to a historic low of .25%, which remains at that same level today.  In March, the U.S. stock market formed a significant bottom and continued to advance with little resistance throughout the year.  Recently we received even further confirmation of the economic recovery from the third quarter GDP growth rate, as it expanded at a better then expected rate of 3.5%.  The next logical step in the economic sequence is to see improvement in employment numbers and other lagging economic indicators. 

What Does this All Mean for Investors?

Only after a confirmation of the peak in unemployment will the Fed decide to raise the federal funds rate and begin to slow down the growth of the economy.  As of today, the Fed is still several months away from beginning to raise rates. In keeping with business cycle history, the Fed’s loose monetary policy has led to stock market strength prior to the peak in unemployment.

As you can see the unemployment rate alone is clearly not a valid reason for investors to be sitting on the sidelines during this ongoing cyclical bull market. In contrast, the current unemployment numbers suggest that investors should expect higher stock prices in the months ahead.

Thank you for reading and I look forward to writing more articles in the future! As always, please feel free to contact me should you have any questions or concerns regarding the website.

-Jim

Special Message

During the past week this website has received two accolades’ that I would like to share with everyone.  First, you might have noticed the new Seeking Alpha Certified graphic in the sidebar. That graphic has been added to the website because I was invited to become a contributor to the financial website.  Please click here to become a follower of my postings on Seeking Alpha!

Secondly, the website was also placed on Accredited Online Colleges List of Top 100 Money Experts you should follow and learn from on Twitter. Click here to read the full article; I am listed at #56.  

Jim Kopas Investments