That’s why, while bonds might seem risky given their strong run during the last few years, I’m compelled to be a bull right now, no matter what happens in Iraq.

First, and most important, the trend in bond prices is still up (with bond yields heading down). Regardless of the news cycle, the market moves in trends, which tend to persist longer than most people tend to believe. Indeed, more than any other reason, the best argument to be a bond bull is that the bond market itself is strong.

Second, as we pointed out last week, the prevailing attitude toward bonds these days is doubt. Talk to most pundits, and it’s just a matter of time before cash “on the sidelines” goes rushing back into stocks. Recent rallies have been just “safe haven” buying — nothing substantial, just a temporary “flight to quality.” Given the long bull market in bonds, buying them these days (and thus betting on lower interest rates) seems, well, a bit stupid. From a contrarian’s perspective, this is bullish for bonds.
Perhaps the most convincing argument for bonds, however, is that they’re just plain cheap. You see, in trading, like most things in life, our perspective is shaped by experience. With bond yields as multidecade lows, most people’s experience has been that of generally higher interest rates than the market is now offering.

The problem with most people’s history, however, is that it starts right around the introduction of color TV. Truth be told, from wars to global depression (and a major stock-market crash), there’s a heck of lot of important history that occurred in the first half of the 20th century.

And while bond yields might feel unbearably low compared with earlier periods in our lifetimes, longer-term data suggest that yields aren’t low at all. For example, high-quality corporate bonds, now yielding more than five, sported yields well below three for much of the early 1900s. A similar example can be found in long-term government bonds, up strongly in price and still yielding more than 4.5 today. From 1925 to 1959, yields topped four only twice.

The funny thing about history is that it has a tendency to repeat itself. So despite their huge drop, it’s important to know that interest rates have traded much lower in the past.

As we often like to point out, it’s strong technique, not security selection that ultimately determines success. But because the future is always uncertain, the best results come by following the market and not your gut. And although real moves take time, I still believe that fixed income is a smarter risk than equities right now. From even a cursory glance at the long-term data, it would appear that history is on my side.

– Originally on Mar 17, 2003 by Jonathan Hoenig

These days, the rising tide continues to be in bonds and other income-oriented instruments. We’ve been talking about bonds for quite a long time here, most recently in January. Although I admit that I’ve been repeating myself on this issue, I also know that this is the nature of bull markets: They move in trends, and trends often last a lot longer than most people expect.

The rise in bonds, and their continued outperformance relative to stocks, has been so dramatic that many market players are speculating that we’re in the midst of a bubble. But from my perspective, it’s not a bubble at all. It’s simply a bull market.

As we’ve been emphasizing for years, a big part of successful trading is avoiding the herd. And while bonds have exhibited strong price performance, I’ve yet to see any real evidence that the herd is running into fixed income.

First off, let’s remember that strong price performance doesn’t necessarily indicate big changes in herd mentality. Ask most people about bonds these days, and they’ll chalk up the strong performance to “safe haven” buying. Indeed, even on supposedly sophisticated business television, you hear the same shockingly ignorant analysis: that bonds are rallying simply because investors are scared and are seeking safety.

But as we pointed out last summer, many commentators are often quick to inaccurately interpret a market move as the result of some action of investors. The truth is, it can also be their inaction that’s ultimately responsible. Remember: The law of supply and demand is also the law of demand and supply. Often it’s not the presence of buying, but the absence of selling, that can make a market move higher.

The fact is, bonds are strong. Is it war fears? The slowing economy? Hedge funds caught short? Who knows. The point isn’t to understand why bonds are outperforming, but simply to know that they are outperforming. So instead of discounting the market’s strength, let’s study it.

A classic characteristic of a bubble is an explosion in both volume and public participation. One way to get a fix on both is to examine the activity in exchange-traded funds, the now ubiquitous mutual funds geared toward aggressive retail investors.

Just take a cursory look at the trading volume of the iShares bond ETFs. I first wrote about these products just after their launch last year, and I followed up by naming them as one of my “favorite things” last December. One indication that there’s no major bubble or public participation in these instruments is that despite continued price outperformance, their volumes remain well below that of your average midcap stock.

Indeed, if there’s irrational exuberance in bonds, you certainly aren’t seeing it show up in the fixed-income version of the QQQs (QQQ). According to Yahoo! Finance, the iShares Trust Lehman 20+ Year fund (TLT), which tracks long-term Treasurys, trades approximately 203,000 shares a day. Compare that with the QQQ, which still — even after three years of the worst bear market in history — averages more than 68 million shares a day.

Volume is one telling sign, public sentiment another. As painful as it might be on this anniversary of the Nasdaq’s all-time high, think back to the euphoria surrounding tech stocks in late 1999 and early 2000. The prevailing attitude at that time wasn’t fear, but greed. From cabbies to CEOs, people weren’t just talking about tech stocks — they were buying them by the truckload. Technology mutual funds couldn’t be opened fast enough, and Cisco (CSCO) became a household word. The returns weren’t just handsome — they were grotesque. In 1998, Amazon.com (AMZN) was up 966%, CMGI (CMGI) was up 605% and AOL (now AOL Time Warner (AOL)) was up 585%.

And this is precisely why I’m still betting on bonds. In the early stages of a real bull market, the prevailing attitude isn’t greed or even fear, but doubt. Gains are viewed as temporary events, chalked up as short covering, program trading, war fears…just about anything but the start of a legitimate bull run. And while the returns on bonds have been strong, they haven’t yet reached the mania stage implicit in an unsustainably speculative boom.

As we always like to point out, there’s never a substitute for proper trading technique. But when it comes to security selection, all signs are telling me that right now, the real bull market is still in bonds. And if the history of Nasdaq 5000 is any guide, this isn’t a bubble, but just the beginning.

– Originally on Mar 10, 2003 by Jonathan Hoenig

While the market has swooned, the public fascination with stocks as an asset class has barely budged. Even after another tough year in equities, by and large, stock ownership is still seen as the golden goose. Fund flows have slowed, but make no mistake: The herd is still in stocks.

Meanwhile, precious few have any indication of what’s been going on in the bond market, which continues an unprecedented bull run. Yes, the stock market has rallied from the lows of late July, but I would suggest the huge move we’ve seen in bond prices is the real capital-markets story since last Sept. 11.

As regular readers of this column know, I first started talking about bonds and the importance of portfolio income more than a year ago. Yet even given the dramatic outperformance of fixed-income securities since then, most investors are still apathetic at best. Even the recent introduction of bond ETFs hasn’t encouraged a more active approach to this oft-misunderstood asset class.

Granted, the limited return of bonds seems unglamorous compared with the potentially unlimited upside of stocks. But, truth be told, bonds are where the real power is. Why’s that? While shareholders technically own the company, their ownership claim comes after that of bondholders.

If bonds seem expensive relative to stocks these days, it’s probably because we’ve become accustomed to the notion that bonds should yield more than stocks.

But it might surprise you to learn that during the early part of last century, the yield on stocks was substantially greater than that of bonds. From 1925 to 1955, the dividend yield on the Standard & Poor’s 500 averaged well in excess of 4%, more than double that of long-term government bonds. It was only in the late 1990s that yields began to crash the 3%, 2% and 1% levels, with interest income and dividend yield being replaced by an emphasis on capital gains.

In the old days, the notion was that stockholders needed to be compensated by a fatter dividend to account for the risk associated with a lesser claim on a company’s assets. And while I’m no economist, it does stand to reason that bonds should yield less than stocks because a bond is, by definition, a superior claim on a company’s assets. That’s why the seemingly high prices of bonds these days don’t bother me at all.

When you consider recent events like the WorldCom (WCOEQ) debacle and the Enron (ENRNQ) implosion, you can appreciate my logic. When a company fails, bondholders might get at least some of their money out. Stockholders get left holding the bag, which is usually empty.

Yet even given the huge losses in stocks and a mad run in bonds, the 10-year Treasury note is still yielding roughly double the yield on stocks. To me, that’s an opportunity too good to pass up in this climate.

Traders focused on absolute return should be constantly evaluating the relative merits of each asset class. After all, you want to buy what’s in fashion, not what’s in the history books. And while the huge run in bonds and correspondingly low level of interest rates might give one the feeling they’re getting in at the top, I’m still buying bonds.

In the final analysis, while nobody knows what’s going to happen next week, the trend is always your friend. From an asset-allocation perspective, bonds might feel expensive at current levels, but history could prove them to be darn cheap.

– Originally on Sep 09, 2002 by Jonathan Hoenig

Like a four-star film, a successful trade is carefully planned, meticulously researched and delicately executed. And when it comes time to put money on the line, investors should not only like the trade, but also the product they’re trading. Making the right trade at the right time using the right product well, it feels like heaven on earth.

Despite the paternalistic tone coming from nervous regulators these days, new investment products continue to be developed at a speedy clip. Keeping abreast of the latest innovations is critical so that, like Batman, you can pull them out of your utility belt at just the right time.

Some products are outright flops. Folios have been moribund since their much-heralded inception a few years back. The same goes for the Chicago Mercantile Exchange’s bankruptcy futures and the Chicago Board Options Exchange’s options on mutual funds, neither of which gained sufficient volume to justify their existence.

Oftentimes, however, investment products look like flops at first simply because they’re a bit ahead of their time. For example, while the Standard & Poor’s Depositary Receipt, or Spider (SPY), was introduced in 1993, it didn’t really take off until the later half of the 1990s, when the market became much more index driven. International exchange-traded funds, or ETFs, got their start as New York Stock Exchange-listed “Country Baskets” and American Stock Exchange-listed “Webs” (World Equity Benchmark Shares) — both of which languished as world markets underperformed the U.S. during the late 1990s. Webs have since been remarketed as “iShares” and have enjoyed steady (although not spectacular) interest from individuals and institutions alike.

While they’re still in their infancy (with more still to come), I believe the recently introduced iShares fixed-income ETFs are the most exciting new products since the Nasdaq-100 Trust (QQQ). Although bonds have a decidedly ho-hum reputation, the new ETFs’ low-cost, ease-of-use and liquidity offer stock jocks trading opportunities previously available only to futures traders or big institutions.

Although Morningstar’s Christopher Traulsen considers trading bond ETFs “about the dumbest idea we can think of,” I believe using the new iShares to better understand, track and (gasp!) trade the bond market represents a major opportunity for income investors looking to take their game to the next level.

While bonds are usually thought of strictly as stable income investments, their prices do fluctuate — often quite dramatically. Since April, the average 30-year bond fund has gained almost 10%, thanks to a major drop in long-term interest rates. Indeed, despite the national obsession with the Federal Reserve, it’s the market that sets interest rates. And because the market can be volatile, bonds — like stocks — can be traded for short-term profit.

Although there are thousands of bond mutual funds to choose from, with the exception of the CBOE’s thinly traded interest-rate options and Merrill Lynch’s soon-to-expire Bond Index Note (BNX), I can’t think of a (non-futures) product that offers individual investors the ability to short sell bonds (that is, bet on higher interest rates) as easily as the new fixed-income iShares. While investors in years past could buy gold funds or short utility stocks to capitalize on rising interest rates, shorting bonds (or bond fund ETFs) outright is much more of a pure play on higher rates.

In addition to serving as long vehicles for income or short vehicles as hedges against higher rates, the new fixed-income ETFs will probably be used in conjunction with another instrument as one leg of a spread. We’ve previously discussed spreads within the context of both closed-end funds and Japanese stocks. Generally speaking, a spread consists of a long position paired against a short position in a correlated sector.

The new instruments will allow you to game the yield curve just as institutions do, going both long and short various maturities in accordance with your own expectations regarding rates. In addition, trades can be developed that isolate particular types of risk. For example, pairing a long position in Goldman Sachs InvesTop Corporate Bond (LQD) or a similar open-end bond fund against a short position in the Lehman 7-10 Year Treasury (IEF) can expose a portfolio to business risk while minimizing interest-rate risk.

We’ll unpack a number of trading ideas over the next few months. The important thing to realize now is that this new ability to go long and short specific points on the yield curve (without a futures account) represents a major step forward in portfolio flexibility, no matter how big or small that portfolio might be.

– Originally on Aug 19, 2002 by Jonathan Hoenig

And while we are influenced by the past, we live and trade in the present. TV’s talking heads have an explanation for everything, but the truth is there are no rules for how the market “should” act.

So in positioning my portfolio, I start by erasing any preconceived notions about how a trade might turn out. It’s a technique that entails keeping not only your eyes open, but your mind as well. In short, assume nothing. When everybody knows something is so, it usually ain’t.

One of the things everybody knows is so: When the Federal Reserve cuts interest rates, the stock market rises. But after six rate cuts and seven months, the big caps are still underwater year-to-date. Fighting the Fed hasn’t exactly been that bad a strategy lately.

Another mistaken assumption is that a successful company equals a successful stock, when, in fact, a company and its stock are actually two very different animals. But it’s that simplistic logic that led people to take huge positions in Cisco Systems (CSCO) because “the Internet isn’t going anywhere,” or to buy Palm (Palm) the day it went public because they “believed in the product.” If only it were that easy. There’s a reason we haven’t seen Peter “Buy What You Know” Lynch’s smiling face recently.

But perhaps the most dangerous article of faith is that equities will continue to be the best-performing asset class over the “long term,” or at least over their own individual holding period. It’s a commonly held view among investors of all sizes, from Joe Sixpack to Joe Battipaglia. Even a 60% haircut on the Nasdaq hasn’t really shaken this faith. When it comes to overall asset allocation, equities continue to dominate most people’s portfolios.

Let’s start with the pros: Tom Galvin, market strategist at Credit Suisse First Boston, recently reduced his earnings estimates on the S&P 500 but maintained his firm’s model portfolio of 70% stocks, 20% bonds and 10% cash. UBS Warburg’s U.S. portfolio strategist, Ed Kerschner, also cut his 2001 earnings outlook but kept his model portfolio 77% in stocks, 18% bonds and 5% in cash. Cautious on the economy perhaps, but still very bullish on equities. J.P. Morgan Chase’s chief portfolio strategist, Doug Cliggott, also cut estimates, although he left his firm’s asset allocation at 60% in stocks, 20% in bonds and 20% in cash. A bullish albeit more balanced call.

Despite a slight drop in June, mutual-fund investors still have more money in stocks than they do in bond and money-market funds (both taxable and tax-free) combined. According to the latest reading from the Investment Company Institute, over 53% of the total assets in mutual funds are invested in stocks.

You don’t have to look very far back to see that such faith hasn’t always been rewarded. Back in 1950, only 16% of pension-fund assets were held in stocks, vs. 75% in bonds and the balance in cash. But as the Dow rose, so did stock-market investments, climbing to 75% of pension-fund assets in late 1972 — just as stocks began one of the worst bear markets in history. The current asset allocation for Calpers, the country’s largest pension fund, isn’t much different. According to its most recent release, Calpers holds roughly 63% of its assets in equities, with only 29% in bonds (the “target” allocation for bonds is actually lower at 28%). Egad! We can only hope the state of California will manage its pension plan better than its energy plan.

When I review prospective clients’ portfolios, I’m always most surprised not by what they’ve bought, but what they haven’t: bonds. They’ve all got the usual suspects: Cisco, General Electric (GE), perhaps some growth or international mutual funds. But when it comes to bonds, the cupboard is bare. Many are eager to discuss earnings announcements or the Nasdaq’s latest move. But ask them about interest rates and their enthusiasm doesn’t just wane, it dies altogether.

“Bonds are boring…nobody ever makes any real money in bonds,” they tell me. Say what? Tell that to holders of the Parnassus Fixed Income fund (PRFIX), up over 10% year-to-date, or to those fortunate enough to own BlackRock International Bond fund (CIFIX), up almost 11% over the last 12 months. Even as the bond market has outperformed stocks soundly over the past few months, public interest (read: investment) in bonds remains tepid at best. Search the Yahoo! message boards for “stocks” and you’ll find almost 40,000 posts, but a similar query for “bonds” revealed just 3,000 mentions.

Indeed, for most investors, coupons are still something clipped from the local newspaper. Maturity is what’s lacking in their younger siblings and yield means waiting for pedestrians at a cross walk.

And these days, there’s growing consensus, even among experienced professionals, that interest rates have bottomed. Yields, now near long-time historical lows, are bound to start ticking up soon, sending bond portfolios down. Think so? Time to check your premises!

In 1996, the S&P 500 posted a blistering return of 22%, and I can distinctly remember feeling as if 6400 on the Dow was as high as it could ever go. Trees don’t grow to the moon, I told myself — better lighten up and prepare for the inevitable drop. BusinessWeek, like many publications, was equally cautious, telling readers of its “Where to Invest in 1997″ issue that “stock market returns in 1997 will be far below those recorded during the past two years. Investors should expect a more modest 10% total return.” Of course, we were all completely wrong: The S&P went on to gain 33% in 1997, 28% in 1998 and 20% in 1999. While I can’t speak for BusinessWeek, I’ve long since learned my lesson. Trends, both in the market and in life, tend to persist, often longer than anyone believes they will. So forget the Fed. Forget the employment data, inflation or the dollar. Forget earnings, Abby Joseph Cohen and the broker urging you to hang in for “the long haul.”

Sure, the stock market has historically been the best-performing asset class, but I’m simply not content to twiddle my thumbs and wait patiently to see if history repeats itself. The fact is bonds have been strong. Strong securities tend to get stronger, while weak securities tend to become weaker. So while the world is waiting to call the bottom in the Nasdaq, I’m putting new money to work in the still-strong bond market.

Stock investors are essentially betting on the come. They’re assuming that the Fed’s interest rate cuts will stimulate the economy, revitalize earnings and send the market’s innumerable fallen angels back to their lofty highs. Meanwhile, bonds continue to march higher, leaving most investors standing at the proverbial plate.

I listen to the market, not to the analysts. And while you’ve seen terrific performance from the bond market in recent months, most people are still dogmatically convinced that the stock market will be higher in 10 years. Why? Because that’s the way it has always been. In my book, that isn’t just a leap of faith…it’s a death wish.

All around me, in short, I see it taken as an article of faith that large-cap stocks will move higher, and that bond prices will fall. And until that credo is abandoned, your best bet on a total-return basis might be in bonds.

– Originally on Aug 02, 2001 by Jonathan Hoenig

For many of us, cash comes in the form of a money-market account, usually either linked to a brokerage account, bought from a mutual-fund company or sold by a bank. Only bank-sold money-market funds come with FDIC insurance, but all suit the same general investment goals: safety and high liquidity. They are essentially savings accounts — and they’re more for peace of mind than for profit. The problem with money-market accounts is that, in exchange for liquidity and protection of principle, we forfeit the higher returns that come along with even slightly more risky investments. For example, E*Trade Group’s (ET) money fund currently yields 3.7%. Fidelity’s is in the high 2% range. Not exactly champagne wishes and caviar dreams.

But with sound cash management, you can do better. You manage a cash portfolio just as you do a stock portfolio. Using appropriate position size, money management and risk controls, you can improve results with only marginally higher levels of risk.

As I wrote last week, traders have a tendency to suffer from “all or none” thinking. Either they’ve got 100% of their money in Cisco Systems (CSCO), or all of it stuffed under the mattress. But you can shoulder more risk without being reckless. You’ve got a money-market fund, and that’s great. Now spice it up. Throw in some emerging market debt or closed-end junk. From riskier bonds to longer dated certificates of deposit, there’s an opportunity to diversify.

Compared to the hallucinogenic returns of years gone by, squeezing a few extra tenths of a percentage point out of your cash might not seem that significant from month to month. But over time, it can really add up. Let’s assume you’ve got $10,000 set aside for long-term, low-risk savings. Over a 25-year period, the difference between a 3% compounded annual return and a 4% annual return is staggering. If you earn just 3%, you’ll end up with $20,937, but 4% garners $26,658. Average 4.5% over that same period, and you’ll bank $30,054. That’s 83% more return on “just” 1.5% extra juice each year.

This is what’s really behind the “long-haul” rhetoric that we so often hear as a reason for owning stocks. The power lies in the mathematical effects of compound interest, not in equities as an asset class. Even low levels of investment return make money grow exponentially when allowed to consistently compound over time. No wonder Ben Franklin called compounding “the eighth wonder of the world.”

One lay-up in the search for higher yields is certificates of deposit — which, depending on the term, are now paying significantly more than money-market funds. Bought through a bank, CDs offer FDIC insurance, no commissions or brokerage fees, and pay a fixed rate of comparatively high interest. For example, as of early July, the top one-year CDs are paying 5%. Longer-dated maturities pay even more.

The hook with CDs, of course, is that there is no liquidity. Certificates of deposit come in maturities ranging from one month to five years or more — but in exchange for higher interest, you give up the right to get to your money. Unless you pay a hefty early-withdrawal penalty, CDs are essentially “locked” until they mature. Personally, when it comes to saving money, I find the “no withdrawal” policy more of a help than a hindrance: It’s harder for me to spend money when I can’t get at it.

Like money-market funds and CDs, the other instruments you’ll use for cash management are all debt of one form or another. So in managing your cash, you are really a bond trader, and while stocks get all the glory, the biggest and most important market in the world is the bond market.

In this market, “buy low, sell high” is reversed: The idea is to lock in high rates before they go lower and avoid getting stuck in low rates as they go higher. A year ago, for example, the yield on the benchmark 10-year government bond was 6%. Now the same bond pays in the low 5% range. There are dozens of high-quality bond funds that can boost your overall return. The main consideration here is duration. Long-term bonds are more sensitive to changes in interest rates, and if rates spike, these funds will tank. So despite their “safe” image, it’s possible to lose money investing in a bond fund.

And some bond funds are clearly riskier — and potentially more rewarding — than others. Emerging-market bonds funds are poised to become the sleeper hit of the year. They are up 8% year-to-date, 5% in the second quarter alone. Despite some volatility, high-yield or “junk” funds are also hanging in. The low cost Vanguard High Yield Corporate fund (VWEHX) is up a respectable 2% year-to-date. Convertible bond funds are outperforming, too. But remember: These are much riskier propositions than money-market funds or CDs. Like extremely strong seasonings, they should be used judiciously to spice up your cash portfolio.

So there’s more to “cash” than a money-market fund. So pick a benchmark — say the Lehman Brothers Aggregate Bond Index — and see if you can beat it. Allocate 5% here, 10% here. Keep more cash than you need on hand. Don’t aim for home runs, but consistent singles. Risk, not recklessness.

– Originally on Jul 05, 2001 by Jonathan Hoenig