Reflection Series: Investing in Bonds

Bond investing should be easier than stock investing, but it’s not. The basic item you’re buying, the bond, represents a promise by a specified entity to make a well defined series of payments. Other than understanding the probability that the issuer will have the money to pay and an appreciation for any clauses that may allow early redemption, the bond can be mostly defined by an interest rate and a final date of repayment. Yet the bond market is less transparent than stock investing and even when you can get the data you need it often seems like bond investing is a maze of confusing jargon terms like “duration”, “roll-up”, “inversion”, and “call options.”

I think bond traders are secretly pleased to have such confusing words attached to their profession, it allows them to hold their own in conversations where commodities traders are talking about “contangoes” or stock traders are “shorting against the box.”

Most of those words can be explained in straightforward terms and I’ve tried to write this article for people who don’t know the jargon without skimping on discussions of advanced tactics and strategies. If you already are a bond whiz you can just skip the bits defining the terms and you’ll still probably find at least one neat tip here. If you haven’t tried to buy bonds before, or if you have but don’t have a full understanding of what is happening with those investments this article should clear up a lot of the confusing doublespeak that seems to surround bond trading.

Bond basics

A bond is basically debt. An issuer is the company or government who borrows the money by issuing the bonds – at which point the buyers pay for the bonds and the issuer gets the money. When originally sold the bonds will be sold in some fixed unit size (such as $1000) with a stated interest rate (let’s say 6% for this example). At 6% the issuer will pay the owner of the bond $60 per year (generally paid in parts every X months) until the “maturation date” at which point the borrower will give the bond owner his $1000 back and the bond will cease to exist. A bond is basically debt with interest. The difference between a bond and a direct loan is that a bond is easily traded in standard unit sizes and typically the bond has a standard contract form.

Bond types

The basic bond types that most people talk about are government and corporate.

The least risky government bond is the US Treasury bond. The US government has the amazing advantage of being able to borrow in its own currency, so the bonds will presumably always be repaid since the US can simply print any needed money. (As an interesting aside the Republican Congress actually threatened to stop payments on US bond obligations in the 1990s during a budget showdown with Democratic President Clinton, but everybody eventually realized that would be a horrible precedent and so to this day US treasuries have never missed a payment.) A few other countries have managed to borrow in local currencies, but most other countries and emerging economies wind up borrowing in bonds denominated in foreign currencies (usually dollars).

The result of this currency difference is that when the borrowing country’s economy has a slowdown their currency weakens and suddenly it becomes much more expensive (in local currency) to make debt payments at the same time as the local economy can least handle higher payments. This vicious cycle has shown up a number of times and has caused several recent bond market disasters such as the Argentinean, Russian, and Southeast Asian collapses of the last few years. Emerging nations have responded by building larger dollar currency reserves so that they can pay off their debts with dollars when difficulties arise, thus defending their currencies.

The second major bond type is corporate bonds. These bonds are issued by companies to raise money for business purposes. Some of these bonds have additional conditions that you don’t typically see in government bonds, such as “call rights” that allow a company to buy back the bonds at certain times (paying back the base debt amount, but depriving the owner of future interest) or “conversion rights” that allow the bond owner to convert it to company stock under certain conditions. Corporate bonds have more variations and are a somewhat wilder bunch than conventional government bonds.

This explanation has focused on the major categories and types. There are also government bonds issued within larger countries (including the US) by states and even by cities. These bonds carry various terms and exceptions and in many cases have different tax consequences.

Bond Price Changes

There is a basic relation between a bond price and the interest rate on that bond. When the interest rate goes up, the price goes down. When the paper says “bond prices strengthened today” you can tell without reading further that the interest rates available are lower. The simple reason for this is that the debt payments on a bond are based on the original issue price, so if Arnold buy a $100 bond from Bob for $105 for whatever reason, the interest the issuer is paying is still based on the issue value of $100. If the bond originally offered 5% on $100, that’s a $5 payment. The payment is still $5 but if you buy it for $105 you are making 5/105 = 4.76% because the price went up.

This price/interest rate relationship is clearest for US treasuries, where the price changes presumably do not reflect changing evaluations of risk (recall that the US treasury is largely considered “riskless”). These interest rates reflect the price the US government pays to borrow money, so it’s also an important value for economic forecasting. When the prices of treasury bonds change it is a relatively straightforward bit of math to calculate the accompanying interest rate change. The relationship between these two is called the “duration” for historical reasons. Don’t let the name fool you, the “duration” of a bond is not the amount of time between issue and maturation or the amount of time remaining on a bond before the capital is returned. The duration is the multiplier that is applied to an interest rate change to figure out the price change of a bond. If you own treasury bonds with a duration of 7 and you read that the interest rate on your bonds went up 0.25% you should expect the market price of those bonds to DROP by 7x0.25% = 1.75%. (This is a large jump, bonds move slowly most of the time.) The image below shows typical duration changes as maturity changes for different types of bonds. The “coupon rate” is the percentage yield payments the bond is making each year. (These used to take the form of coupons that were cut off the bond each year and cashed in.) You can see that for most reasonable coupon rates duration maxes out at about 10 (and yes, the standard units of duration are years – don’t let it confuse you). This means that for a bond of 30 year maturity (and thus duration of about 10) you would expect an interest rate change of 0.25% to result in a price change of -2.5%. One interesting exception to the duration calculation is that bonds which do not make payments (so called “Zero coupon bonds”) have a duration equal to their time to maturity.

Bond "duration" (the variable) versus bond "maturity" (number of years until the bond is finished and the principle is returned. The duration is a handy number that you multiply the interest rate change by in order to get the market price change of a bond. If duration is 10 and a bond yield drops 0.25%, the price on the market should go up about 2.5%

Duration is one of those jargon terms that make bond investing such a mess. I often see the term used in ambiguous ways in even the professional financial press. Some writers use the term duration in the sense of the price multiplier, above, and also in its conventional English meaning as a period of time – sometimes in the same paragraph! [Click here for more math on bond duration]

Bond yield and maturation

Bonds typically return a higher percentage rate (or yield) if they have more time until maturation. Another way of thinking of this is that people want a higher interest rate if they are going to lend money for longer. A longer term loan involves more risk that the borrower will default, or that interest rates will change, or that the lender will find a better potential use for their money. In our everyday lives this manifests as cheaper loan rates for a 15 year mortgage versus a 30 year mortgage, for example. A chart of these rates (known as yields) forms a curve and is known as a yield curve.

This would be a "normal" yield curve. Short term loans do not get paid as much interest as long term. The range (30 years) is set by the longest maturity common issue US Treasury bond, and is also the most common long term mortgage issue.

The relationship between bond maturation date and interest rate changes over time. It is influenced by the market demand for bonds and also by estimates of what the prevailing interest rates will do in the future (if you think interest rates are going to go up in a few years, you will want a higher rate on a loan that extends into that time). Sometimes, however, prices fluctuate such that interest rates on longer loans become LOWER than interest rates on shorter rates. This is known as an “inverted yield curve” because the relationship between the future and present yields is the inverse of the usual relationship. When the short term and long term yields are about equal we get what is known as a “flat yield curve”.

"Flat" and "Inverted" yield curves, made with recent data. Each of these leads to different short term strategies that hedge funds and banks engage in to profit from the shape. The cause of these is open for debate but some causes are traceable.

Advanced strategies

Bond Roll-Up

Take a moment to look back at the normal yield curve above. A 10 year bond normally trades at a higher interest rate than a 5 year bond, so what happens if you buy a 10 year bond and hold onto it for 5 years? You will collect the interest for 5 years, but you will now be holding a bond which will be paid off in 5 years which means that the market will value it as a 5 year bond. The interest payments remain the same, but since the market now values the bond as a 5 year bond it will probably trade at a lower effective interest rate and since prices of existing bonds move in the opposite direction of interest rates the price goes up. Another way of looking at that is that once a bond (any bond) has lived part of its life it becomes a shorter term loan and becomes more valuable since more people are willing to loan shorter term money. The increase in price of an aging bond is called “roll up.”

This strategy becomes more useful when the yield curve is steepest, because a larger change in interest rate leads to a larger increase in price. When the bond curve is flat you can buy long bonds and wait for them to age while the bond curve gets normal again and try to profit from both events.

The Carry Trade

When the yield curve is steep the bond roll up strategy above is widely practiced. The "carry trade" is the opposite strategy: it is widely practiced when the yield curve is inverted. When the curve is inverted an investor can borrow long-term money (by selling long term bonds short to generate cash for the strategy) and then loan short term money by buying short term bonds. The lower shield on the long term bonds means that more money is made from selling those bonds than by buying the short term bonds, resulting in profits. When the maneuver is completed the investor is left holding short term bonds and owing long term bonds, which is fine as long as the prices balance somewhat but can leave the investor owing money if the yield curve reverts to its normal shape. During the recent yield inversion a lot of hedge funds practiced this strategy, and some of them lost some money when they didn’t get out in time.

To further enhance the carry trade some market players also use different types of bonds for the two parts of the transaction. One recent example was that hedge funds were borrowing their money in Japan at nearly 0% and loaning it in Iceland and Turkey at 3-5%. It was possible to make a lot of money this way, but currency changes and bond market volatility make the strategy risky.

Bond risk

Each bond has some chance of default, which means that it will not be paid off. The US treasury bond is usually used as the “riskless” standard so you will often see comparisons of bond returns made to US treasury bonds or see the US treasury bond referred to as “the riskless asset”. Corporate and government bonds are usually given risk ratings by a number of rating agencies such as Standard & Poor or Fitch rating services. The rating names vary by agency but most are alphabetic and if you see something that starts with anything other than an “A” you should be very wary, the grades are not like school and a “B” is not very good.

The rating agencies use proprietary (and secret) grading methods and companies pay them for the ratings. This has led to some concerns about accuracy and conflicts of interest. The agents of the rating companies are essentially auditors who go into a company and give a credit score based on the books of the company. The rating companies argue that they have to keep their scoring methods secret in order to prevent people being able to reverse the rating to extract non-public information that rated clients have shared with them, but investor advocates have expressed a lot of concerns about the rating agencies keeping methods secret and accepting payment from their audit subjects. Academic studies have shown that the rating agencies are often 2-3 years late in spotting dangerous financial trends at their subject companies.

Fortunately there are alternatives.

I could fill pages and pages with academic debt rating methods, but the most widely used method is the “Altman Z-score” or simply “Z-score” introduced in an academic paper in 1968 by Altman [click for paper]. This score is calculated from publicly available numbers which can be extracted from the published financial statements, although it often requires quite a bit of accounting dexterity to get some of the numbers if the company is complex and has a conglomerated structure or joint endeavors with other companies. The resulting score is the corporate equivalent of a “consumer credit score” of the type that companies maintain on each of us individually. The Z-score has an advantage of being publicly reviewed and criticized so that a lot of people are constantly investigating the Z-score and looking for weaknesses or corrections that might be needed (a quick search found about 150 study papers using the Z-score for comparison or proposing extensions to the Z-score). This review makes the Z-score a very powerful method. Whenever I am concerned about the ability of a company to pay off its debt I calculate a Z-score for the company. [Link to an online Z-score calculator]

The availability of both the private rating agencies and the publicly reviewed Z-score raised a natural curiosity: how do they compare? Several studies have been done along these lines. If you go to this post you can see a chart of how Standard & Poor ratings have equated to Z-scores over time. As the financial system has changed both S& P and the Z-score users have slowly adapted their criteria to adjust for changes in how companies operate and how financial reporting works. The most interesting outcome from comparison studies is that the Z-score changes well before the rating companies adjust their scores, in fact the Z-score typically projects S & P downgrades almost 3 years in advance! To some degree this is understandable since the auditors at the rating companies only visit the company occasionally (remember they have to be paid), but I was surprised that the delay was so long. The next time you read about a bond declining in the market without any rating changes, keep in mind that rating changes are often delayed several years after company problems are visible in financial statements. If you invest in specific corporate bonds you may want to calculate a Z-score every time they release earnings.

Common stock typically becomes worthless during the bankruptcy process because stock represents ownership in the business. Bonds are a loan to the business so typically bondholders recover some value during a bankruptcy. There are a variety of levels of “seniority” of bonds, the more senior the bond the more firm a claim they represent on the assets of the company. I have reproduced a chart from a study showing the average value recovered during a bankruptcy by the various bond seniority levels.

Percentage of principle recovered after bankruptcy by corporate bond type. The different bond "priorities" in the left had column are different categories of bond a company can sell, with different priorities of claims on the company assets in bankruptcy. The safer ones are at the top and the worst ones at the bottom. If the company stays solvent it should pay of 100%, if it goes into bankruptcy this chart gives some average recovery numbers by category. N is the number of bankrupt bonds in that category that were found in the study and used for the calculation.

Bond Trading

Bonds are traded differently than stocks. For many years the market was hidden from investors and a broker would give a price without the investor knowing how much of a markup they were facing because there were not central quote interchanges available. Bonds were traded between the “bond desks” of large institutions and many times the markup on a bond purchase (versus the price the seller gets) could be several percent of the total price! Things are getting much better now with numerous bond supermarkets making some level of quotes available. An investor typically still pays more for a bond trade than a stock trade, but it isn’t nearly as bad as it used to be.

One thing to watch out for is expressed in the old saying that “stocks are bought and bonds are sold.” In many cases bonds (being debt) are pushed quite heavily by investment banks either to clear up their portfolio or to serve a corporate client (for some frightening stories about this see the book “Liar’s Poker”, linked below). If your money manager tries to SELL you a bond, you should become skeptical and carefully review the purchase (and consider changing money managers). The right way to BUY bonds is to come up with a fair idea of what qualities you want and have a look at the available bonds – and if you have enough capital to allot buy several different bonds for diversification. You should also be careful where you buy bonds and be aware of the specific compensation any intermediaries are collecting. I encourage you to click on some of the bond market ads that no doubt show up on this page, but be careful and make sure you are BUYING and not BEING SOLD.

Bond Expertise

Any investor who knows the material above is far ahead of the average bond investor. If you can look into a Z-score (and know how far behind S&P type credit ratings can be) and you know what duration is you will find even many bond articles in the financial press to be humorously ill-informed. The most complex math involved here is only multiplication so you can quickly do checks in your head when looking at the yield, maturation, and price of a bond to consider for investment.

There are still a lot of things that have not been mentioned here. Some corporate bonds have complex terms where the yields follow various indexes, for example. Some regional government bonds are “pre-refunded” where they have a pile of treasury bonds that are sufficient to pay off the bond sitting in a trust – those regional bonds cannot fail to pay unless the US treasury bonds fail. Other bonds may have “insurance” which means that even if the payer fails another company or bank will stand behind the bonds (although that payer may fail as well). There is plenty of room for further reading; the material here is designed to give you a solid foundation to start from.

References

Of Mountains And Molehills…

As we move into the new year and 2010 forecast after forecast hits the Street, invariably the “mountain of money on the sidelines” argument is being put forth by more than a good number of Street seers and pundits as a rationale for bullishness on financial assets, and equities specifically. We’ve heard this same argument again and again for decades now. Invariably these seers and pundits are referring to money market fund balances in their so-called analysis. Don’t get us wrong, over the last few decades we have seen record money market fund balances be created. But the fact is that if you go back to the early 1980’s and move forward, there has virtually never been a down year for money fund balances straight through to 2002. Point-to-point from 2002 through 2006, money fund balances experienced no growth. But you also know that during this exact period, we experienced both a cyclical bull market in equities and a coincident multi-generational residential real estate bubble of incredible proportion. It’s no wonder money fund balances did not grow as it‘s simply not often that we get a double barreled asset class movement as was the case from ‘02 through ‘06. But off to the races with growth in 2007 and beyond has once again been seen in money funds until just recently, punctuated by the safety trade movement of last year and early this. Of course once Bernanke and friends moved the Fed Funds rate to academic zero, dragging money fund rates with it, mom and pop investors have dutifully moved into bond funds in record amounts. Just as the Fed wanted, but ultimately to investor’s detriment when generational low interest rates are no more. The point is that the theoretical “mountain” of money has been on a path of growth for three decades now. The mountain simply grows ever higher and analysts again and again point to it in each cycle as a rationale for yet ever higher financial asset prices (of course completely disregarding the issue of valuation in the investment decision making process using this logic). As we see it, if the mountain of money argument held significant water, we would never have experienced two instances in the same decade where the equity market was cut in half. The so-called mountain of money in money funds should have cushioned such an extreme historical outcome…but they did not.

The fact is that money funds have grown in popularity with a broad constituency of “players” as the decades have evolved. Conservative folks that two or three decades ago would only put their money in banks “found” the sometimes higher yielding money fund complex and shifted investment exposure. But for many former CD buyers who moved to funds, it’s a good bet that money is never destined for equities. The corporate crowd found the fund complex long ago in terms of parking short term cash/working capital assets, etc. as money funds fit the bill - yield, liquid and often safety (govt. funds). You get the picture. The growth in multiple constituencies in money fund owners means there is a ton of money in the fund complex that is never destined for equities. But the analytical community treats money funds as if their owners were homogenous. They are not and that says to us generically pointing to money fund balances and suggesting it is fodder for equities is very poor analysis at best, and disingenuous at worst.

Anyway, we promise the remainder of this discussion will be long on graphics and short on commentary as the pictures tell the story. As opposed to looking at the money fund complex generically and drawing conclusions about fuel for potential equity investment, we’d rather take an analysis of “cash” by investor constituency. Just who are buyers of equities? Households, institutional investors, corporations (buy backs), etc. We want to look at them. Where are levels of cash by constituency relative to current market values? Relative to historical context?

One last quick comment before pushing off from shore. In terms of institutional cash levels, this week the Investment Company Institute reported equity and bond fund cash levels. Near 3.8% at present, equity fund complex cash rests at a level last seen in October of 2007. Relative to total historical context (data going back to the 1970’s) it’s a low number both in relative and absolute terms. The low in October of 2007 was 3.48%. Not quite a mountain at the moment, no?

BROAD MONEY
Although we just got through telling you that we wanted to focus on constituencies, per se, we'll quickly start with a look at the macro. What you see below is the analytical "mountain of money" argument the Street conveniently uses. It’s money fund balances as a percentage of the market value of equities. Again, so you know where this data came from, we’ve used the Fed’s own Flow of Funds numbers for equity values and money fund values also as reported by the Fed. It’s no wonder many a seer and strategist is so bullish, no?

Increasingly money fund balances have spiked in equity market corrections, the spike just becoming larger with each bear market (early 1990’s, 2000 and over the past few years) episode. But we need to remember that with the recent spike in fund balances, many folks were simply seeking the apparent safety of government asset protection, clearly regardless of nominal yield concerns. And that continues to this day. Let’s face it, how does one get close to a zero yield on 3 month T-bills unless safety was still a primary concern for at least a fair amount of investors? So we see the recent spike in fund balances and the ratio of money funds to equity values very much being driven by a run to safety from all asset classes over the October 2007-March 2009 period. That does not mean it will all flow back into equities. Not by a long shot.

Another meaningful macro in our minds is very simple - M2 relative to the value of the equity market. See the recent spike? That’s both equities declining and our friends at the Fed juicing the liquidity (and their balance sheet, of course). But despite both of these anomalistic sets of circumstances, this ratio currently rests below its half century average of 75%.

Um, where’s that mountain of money again?

HOUSEHOLDS

It has been many a moon since we have looked at some of this data, so a quick definitional comment. You may remember that when we have historically calculated household “cash”, per se, we’ve included every bank account, CD, money fund, and every single household bond holding (corporate, Treasury. Agency, muni, etc.). We stretch the strict definition of cash a good bit, but we are essentially trying to give the cash argument all the benefit of the doubt possible. Forget money funds, we’re essentially assuming in this view of life that households would also be willing to liquidate all of their bond holdings (despite record current inflows to bond funds) in a heartbeat to theoretically plow into equities. And what we get as a historical ratio using this methodology is as follows.

We currently rest at approximately a 65% ratio when the average for the entire period for which we have data is 105%. Not exactly a mountain, but a very strong contender for a molehill. Over the last two years (since YE 2007) the combo of household cash and bond holdings is almost flat. The recent spike in the ratio seen above from under 50% to over 70% was driven by the decline in equity values, NOT a major increase in household cash/liquidity/bond holdings.

And why no spike in household cash in absolute dollars as of late? Simple. The household balance sheet deleveraging cycle, which is still in its early stages. Households are paying down and defaulting on debt in addition to increasing savings. We know by looking at the inflows to equity funds this year the numbers are negative, as there has been a net outflow. Flows into ETF’s have been very positive, but on a net basis we believe it’s fair to say the public has not been piling back into equities, despite the near meteoric rise off of the March lows to this point. Although it may sound a bit melodramatic, in an environment like the present where labor market conditions are unsettled at best, wage growth is zero to minimal and household balance sheets remain “offsides”, so to speak, in terms of existing liabilities relative to a big decline in assets, it’s only a natural that households husband liquidity. And even if households are unable to raise significant cash (liquidity), they at least forgo spending what cash resources they have. We believe this thought process is actually playing out as represented by the chart below. We’re looking at household cash relative to total household assets. Remember the broad definition we have brought to the term “cash”. Again, the recent big spike is due specifically to household asset value deterioration (financial assets and RE).

Interesting, no? Clearly from the late 1940’s to the early 1990’s, this ratio was incredibly stable within a roughly 2% point band. This band of experience was broken to the downside in the early 1990’s, reaching its nadir at the top of the residential real estate and equity market cycle a few years back, but has recently returned to that forty year band of experience with the decline in equity and housing values. Does this really represent households raising significant cash balances? Of course not. It’s the drop in the asset side of the balance sheet that has driven the reversion to the mean journey. Does this represent a return to some type of normalcy (although we hate that word)? For now let’s just call it a change back to what was traditional household asset allocation historically. So implicitly analysts are suggesting perhaps households will allocate precious liquidity resources of the moment back to equities? That seems to be the argument. Personally, we just don’t buy it given total household balance sheet circumstances playing out in the here and now. But that’s our opinion.

CORPORATIONS

You know from our coverage over the years that corporations have been meaningful buyers of equities. Of course this activity is caught up in both buyback and cash driven M&A activity. First, you may be familiar with the fact that recent corporate insider selling has been literally swamping buy activity. Personally, corporate insiders seem anything but bullish as we’ve seen recent weekly experience of 30:1 sell to buy ratios, or more depending on the week. But how are they treating corporate cash? If equities are in the bargain bin, shouldn’t buyback activity logically be off the charts? In a period where top line growth is clearly a struggle, doesn’t buyback and M&A activi

ty make sense in terms of trying to advance the bottom line ball past the next first down markers? One would think so. Unless, of course, one is part of the current corporate sector. The following is simply an update of a chart we have shown you in the past. In the bottom clip we chronicle US corporate equity issuance and buyback activity stretching back three and one half decades. Just look at what has happened so far this year. And as we describe in the chart, this activity DOES NOT include the financial sector (who have been prolific equity issuers this year).

Of course the top clip of the chart chronicles the same equity issuance or retirement, but this time alongside is the rhythm of corporate debt issuance or pay down. Up until literally the last quarter 2009 marked the first year in many a moon where on an aggregate basis, corporations have issued both equity and debt. They are raising cash, per se, as opposed to spending it. It was just in the third quarter that corporate debt in aggregate began to contract for the current cycle.

And this is very much dramatic change in terms of corporate influence relative to the size of the equity market itself historically. You can see this in the next graphic depiction the historical magnitude of net equity retired by the corporate sector over time as a percentage of total equity market value. At market highs in 2007, corporations retired 3% of the total value of the equity market. Talk about a meaningful price support mechanism. Too bad they could not have waited just a few years when a lot of these equities could have been purchased at the 50% off sale, right? Admittedly, a meaningful portion of this prior period equity retirement is also attributable to the mini mania in private equity at the time.

As we see it, for now corporations are husbanding liquidity much as appears to be the case with US households. All one has to do is look at the current dynamics of corporate cash flow to get a sense for what we are talking about in terms of corporations acting to protect liquidity. Below is yet another chart courtesy of the historical Fed FOF data. Here we are looking at corporate internal funds generation less capital expenditures. A close proxy to net corporate cash flow? Yes, close enough to get the point across. The issue here is that corporations are not spending on cap-ex. No surprise at all as we have been chronicling this fact all year long whether looking at business surveys or the raw numbers in non-defense and non-aircraft corporate spending. Again, logical. Corporations would be spending if they saw investment opportunities that would exceed the cost of capital. The message is they don't. And wildly enough for the many, the cost of debt capital is near generational lows. That's a loud message.

Without trying to reach for melodrama, we’ve never seen anything like the above. On a hopefully positive note, does this tell us pent up demand for corporate capital spending will be a reality somewhere in the period ahead? 2010? We think so, but we’ll just have to take it one step at a time as for now the corporate purse strings are largely closed for both cap spending and equity buybacks. Quite the opposite is occurring as we are seeing net equity issuance.

A final view of life in terms of “cash” at the corporate level lies below. This go around we’re looking at the longer term ratio of cash at the corporate level as a percent of the total value of the equity market. The long term average rests at 68% and we’re current sitting at 82%, comfortably above that average. But one more time, the change in this ratio over the last few years is a result of equities declining in value. The increase in the actual nominal dollar level of corporate cash since year end 2007 is an overwhelming 2.1%. Peanuts. Remember, we are including corporate fixed income holdings/assets as cash.

Okay, there you have it. You get the picture at this point. The “mountain of money” argument is certainly not completely without some merit, it’s just it seems clearly not to be the big bull argument the Street makes it out to be. Although these are our personal opinions, some of the constituents of equity buyers that are households and corporations are not sitting on “mountains of money”. Moreover, they are showing us directly in the data they are not in the spending mood, whether for capital expenditures, retail sales (currently resting at 2005 levels, as we have been chronicling), or equities. And in the bigger picture of broad money in the system that is M2, the numbers just are not that impressive relative to historical context. What does all of this tell us? There simply does not seem to be huge “pent up demand” for equities that would be funded by existing cash balances among many constituencies of equity buyers. That’s the message. And what does this mean to the near term equity market outlook? To us it means more of a structural support that would be money potentially headed to equities simply isn’t realistic. And as we see life, this says Fed/Government sponsored liquidity has been and continues to be the most important structural support. That and institutional momentum. As we move into the new year it‘s simply this that we follow. Simple enough? A gloomy view of life? We’re simply searching for realism and trying our best to implicitly ask the age old question, "who's the next buyer?"

(from ZeroHedge, December 31, 2009)

Bill Gross on Bond Investments and Inflation

The most important info I heard today on Bloomberg was the opinion of Bill Gross on bond investments. I invest in PIMCO Total Return Fund (PTTRX) managed by Bill Gross and follow Bill Gross' commentaries.

It's crucial to know when to decrease the bond investments because of creeping inflation. Bill Gross estimates that the US may start seeing the signs of inflation only in the end of 2010. The most important signs of inflation in his view are employment data and industrial capacity utilization.

Given the prospect of US government printing money to finance its projects, hearing that the inflation is not expected till the end of 2010 is reassuring.