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The Fed And SLV – What’s Ahead?

Summary The FOMC is expected to raise rates this week. How will this decision impact SLV? Whether the Fed raises rates or not, isn’t the only issue to consider. The FOMC is expected to convene this week and decide whether it’s time to hit lift off and raise rates. While rates are still expected to remain low, even a modest hike of 0.25 basis points could be enough to send down the iShares Silver Trust ETF (NYSEARCA: SLV ). But the direction of the silver market won’t only rely on the whether the Fed raises rates or not. Other considerations also matter including what’s the trajectory of the future rate hikes, the wording of the statement, the revised outlook for next year, and Chair Yellen’s press conference just to name a few. How will the Fed expected hike move the price of SLV? Let’s breakdown what’s up ahead for SLV. Based on the implied probabilities , the market expects three rate hikes in 2015-2016 with a very likely hike in December – a little over 80% chance, the highest level in months. But with an 80% chance this still gives some room for uncertainty in the markets. (click to enlarge) Source: Fed-watch If the Fed does move along with the hike, it’s likely to bring down the price of SLV as it did back in the last FOMC meeting when the Fed stated it’s ready to raise rates in December. Is the market ready for a hike? When it comes to the reasoning for raising rates the Fed sees that the U.S. labor market is on course to full employment with unemployment rate at 5%, an average of over 200,000 jobs were added a monthly basis in 2015 and wage growth at 2.3%. Also, U.S. core CPI is at 1.9%, which isn’t far off the Fed’s 2% target . And the Case-Shiller home price index showed that prices have been steadily climbing in the past three years; while prices aren’t at record high levels of mid-2006, they are still high enough to sustain a rise in mortgage rates and weed out any possible bubbles that may be forming in the real estate market. The same could be said about the stock market. The flip side for keeping rates unchanged is that the labor market may not be in a good enough shape to sustain higher rates with “real unemployment rate” or U6 rate is close to 10% and participation rate remains low. Moreover, the expected rising cash rates will make it even harder for the Fed to reach its 2% inflation goal. And low commodities prices aren’t helping. Having said that, the Fed is still expected to raise rates this meeting. And higher rates won’t do any good for SLV. From the perceptive of the stronger U.S. dollar, a stronger dollar could push down SLV. After all, the rally of the U.S. dollar in recent weeks, up to the last couple of weeks, seemed to have contributed to the weakness of SLV, as indicated in the chart below. (click to enlarge) Source: FRED and Google finance Bear in mind, however, that the correlation between the two isn’t too strong at -0.26 during 2015. But the correlation has intensified lately: Over the past couple of months it reached -0.4. So keep an eye out for the direction of U.S. dollar, which is likely to keep rising if the Fed moves on with normalization. Beyond this time’s rate hike Looking beyond the expected rate hike, the Fed is likely to issue a statement with a dovish tone reiterating that future hikes won’t be every other meeting and will spread apart in 2016 – something that will be backed by the dot plot. Chair Yellen will also try to calm the markets by assuring the strength and stability of the U.S. economy and how another hike won’t be decided any time soon (the term “data dependent” will be thrown a lot – as it always is). The FOMC will also release its dot plot about the cash rate. Back in September, the FOMC anticipated rates will rise to 1.4% by the end of next year and 2.6% by the end of 2017. The trajectory of the cash rate could also have an impact on the direction of the price of SLV. On this issue, if the FOMC were to revise down its outlook about the cash rates, and it’s a very likely scenario, this could partly offset the adverse impact the rate hike in the upcoming meeting will have on precious metals prices. This could translate to keeping SLV from tumbling down in the coming months. Unless the Fed surprises the market, the short term outlook of SLV is still likely to be downward. The expected rise in the U.S. dollar could keep driving down SLV. On the other hand, if the Fed cuts down again its outlook for the cash rate in 2016 and beyond, this could, down the line, keep the price of SLV from further plunging in the medium term. For more please see: Will Higher Physical Demand for Silver Drive Up SLV?

High Yield Carnage And Closed End Funds

Summary High yield bonds are suffering a liquidity crisis that is causing NAVs to fall. Due to their nature, CEFs are less susceptible to a liquidity crisis than bond mutual funds, but they are impacted by the high redemptions elsewhere in the bond market. When the time is right, there will be wonderful buying opportunities in the high yield CEF universe, but that time is not quite yet. With Carl Icahn warning about a “keg of dynamite” in the high yield market and Third Avenue liquidating a high yield bond fund, the so-called “junk bond” market is living up to its name. While markets are victim to volatility every once in a while, the problems in high yield are worrisome for a couple of reasons. Firstly, the high yield market never really recovered from the taper tantrum of 2013, meaning the bad run for high yield has now lasted almost three years: (click to enlarge) Secondly, with a ZIRP environment where retirees are desperate for income, many have been fooled into buying into the high yield market at the wrong time. Many fears around high yield bonds focus on the impact of a rising interest rate environment, but a much greater threat is behind Icahn’s red flag: liquidity. A Quick Introduction to Bond Trading With so much media focus on the stock market, many people translate what they know and learn about equities to the credit markets. This is a huge mistake for several reasons, but right now the mistake revolves around trading. Common stocks trade trillions of times in a day, but bonds do not. In fact, many bonds will not be traded for days, or even months . This is especially true for the high yield market, where investors often hold to maturity to collect the yield. The implications of this are significant. Without frequent trading, a fund that needs to sell its holdings to fulfill redemption demands could suddenly be faced with the worst dilemma you can have in any business: needing to sell immediately with no buyers in sight. When this happens, prices crater. Without the liquidity of stocks or even U.S. Treasuries, high yield bonds are susceptible to a massive decline in values, which is why we have seen the decline in value for these funds accelerate recently. Part of this is because more people are selling out of high yield mutual funds, which is requiring the funds to sell to give investors back their cash. In doing so, they are driving prices down, and the trend is likely to continue. Why CEFs are a Good Thing The timing to buy into high yield is not good; as Icahn rightly says, the devastation is likely to continue. There is still money in high yield funds that is likely to come out, and there are still continued fears about rising defaults in energy that are impacting the credit markets more broadly. But when the time to buy into high yield is right, CEFs may be a better alternative than mutual funds for yourself and the market as a whole. If well managed, CEFs do not face the redemption issue that mutual funds do. Because their total number of shares is fixed upon IPO, investors don’t “redeem” their holdings for cash-they sell their stake in the fund to someone else. This means that there can be a steep decline in the market price of CEFs that will not force the CEF to sell bonds. The only time the fund needs to sell bonds is to pay dividends (if its net investment income is less than its distributions) or to free up capital to lower leverage. A well-managed CEF can avoid both by cutting dividends (as we saw many high yield funds do in the last two years) and by lowering leverage (again, a tactic gaining popularity in these funds). This doesn’t mean CEFs are insulated from the bond market carnage; since they are trading in the same market, they are suffering alongside everyone else. But this suffering can take many forms: it can mean that the NAV of its holdings declines, but if the fund holds the bond to maturity, it will get its already invested capital. If the fund doesn’t need to sell the bond prematurely to pay dividends or lower leverage, it can weather the storm of a collapsing high yield market. I believe this is partly why the Pimco High Income Fund (NYSE: PHK ) made its unprecedented dividend cut a few months ago. Predicting a need for cash on hand and a need to stay as far out of the high yield market as the fund’s mandate will allow, it has lowered leverage and lowered distributions to effectively lower its liabilities and liquidity needs. This is prudent, and affirms my confidence in management if not in the wisdom of buying PHK right now. Other funds have made similarly wise decisions, as I discuss below. Picking through the Carnage So where does that leave us now? Several high income CEFs are down massively and will be well positioned to buy when the liquidity crisis in the market is over. But which to choose? (click to enlarge) A comparison of eight funds with relatively similar mandates and investment strategies reveals a lot of similarities and some telling differences. Most significantly, the Deutsche High Income Opportunities Fund (NYSE: DHG ) and the Deutsche High Income Trust (NYSE: KHI ) have the best performance of the group-ironic, since DeutscheBank (NYSE: DB ) has had an awful year. But “best” in this case means a negative total return YTD including dividends and an erosion of 10% of capital on average. The worst performer, the Pioneer High Income Trust (NYSE: PHT ), is down over 46% YTD and is at its lowest point in the last year. A dividend cut in February, which now seems like an extremely prudent decision given the liquidity needs of the high yield market throughout the year, is mostly to blame, and has resulted in the stock trading at a discount to NAV consistently throughout the year. In contrast to this is PHK, which is down 32% YTD but is the only fund to trade at a premium. Just a few weeks ago, however, that premium was as high as 30% just a few weeks ago, which is what caused me to sell the fund . A Group of Peers Looking at the others, we see comparable discounts to NAV among the Invesco High Income Trust II (NYSE: VLT ), the Dreyfus High Yield Strategies Fund (NYSE: DHF ), and the Credit Suisse High Yield Bond Fund (NASDAQ: CHY ). Worse than these is the First Trust Strategic High Income Fund II (NYSE: FHY ), a thinly traded fund that has also performed worse than the others. In addition to a reverse split in 2011, FHY cut its dividend earlier this year. Even more distressingly, the fund failed to see its NAV recover after 2008, although many other funds were able to recover against their lowest point in the dark days of 2009: Combined with First Trust’s small size and thus relatively limited buying power in bond markets, these distressing signals indicate this is not a fund to buy on the dip. The Standout Of the rest, DHF is one of the strongest contenders for a variety of reasons. For one, its dividend cut came in the middle of February and it has not cut in 2015. I interpret this as an indication of the managers’ prescience; simply put, they saw the liquidity crisis before others. Additionally, the fund’s effective duration of 3.72 years is extremely short for the high yield CEF universe and only 5.67% of its portfolio is in energy: (click to enlarge) Finally, to cover dividends, DHF will need to earn a 10.88% yield on its portfolio since it is trading at a discount. This is easy to do even in a ZIRP environment, and is getting easier now that junk bond yields are rising: (click to enlarge) A high yield fund starting today could get that yield with only 20% leverage–much lower than the level many bond CEFs maintain. Leverage is my main concern with DHF, however; at over 30%, it is excessive in this cratering high yield market, which is why I am not buying DHF now and will not for a while. However, when the time is right this fund may be one of the best options in the high yield market, although if the premiums shrink and discounts grow for other historical strong performers like PHK and PHT, they may become attractive too. For now, however, I am fully out of the high yield market and will likely remain so for several months.

Assessing The Utility Of Wall Street’s Annual Forecasts

It’s that time of year when everyone starts preparing for the New Year and Wall Street makes its 2016 predictions. I’ll get right to the point here – these annual predictions are largely useless. But it’s still helpful to put these predictions in perspective, because it highlights a good deal of behavioral bias and some of the mistakes investors make when analyzing their portfolios. The 2016 annual stock market predictions are reliably bullish. Of the analysts that Barrons surveyed, they found no bears and an expected average return of 10%. This is pretty much what we should expect. After all, predicting a negative return is a fool’s errand given that the S&P 500 is positive about 80% of the time on an annual basis. And the S&P 500 has averaged about a 12.74% return in the post-war era. So, that 10% expected return isn’t far off from what a smart analyst might guess, if they’re at all familiar with probabilities. There is a chorus of boos (and some cheers) every year when this is done. No analyst will get the exact figure right, and there will tend to be many pundits who ridicule these predictions despite the fact that expecting a positive return of about 10% is the smart probabilistic prediction. In fact, if most investors actually listened to these analysts and their permabullish views, they’d have been far better off buying and holding stocks based on these predictions than most investors who constantly flip their portfolios in and out of stocks and bonds. But that’s the reason why these predictions exist in the first place. Because every year, investors perform their annual check-ups and evaluate the last 12 months’ performance before deciding to make changes. And of course, Wall Street encourages you to do exactly that, because turning over your portfolio means increasing the fees paid to the people who promote these annual predictions. But when we put this analysis in the right perspective, it becomes clear that this mentality is misleading at best and highly destructive at worst. Stocks and bonds are relatively long-term instruments. The average lifespan of a public company in the USA is about 15 years.¹ And the average effective maturity of the aggregate bond index is about 8 years.² This means an investor who holds a portfolio of balanced stocks and bonds holds instruments with a lifespan of about 11.5 years. When viewed through this lens, it becomes clear that evaluating a portfolio of long-term instruments on a 12-month basis makes very little sense. What we do on an annual basis with these portfolios is a lot like owning a 12-month CD that pays a one-time 1% coupon at maturity and getting mad that the CD hasn’t generated a return every month. But this annual perspective makes even less sense from a probabilistic perspective. As I’ve described previously , great investors think in terms of probabilities. When we look at the returns of the S&P 500, we know that returns tend to become more predictable as we extend time frames. And the probability of being able to predict the market’s returns increases as you increase the duration of the holding period. While the probability of positive returns becomes increasingly skewed as you extend the time frame, there is still far too much randomness inside of a 1-year return for us to place any faith in these predictions. The number of negative data points is only a bit lower than the number of positive data points, even though the average return is positively skewed: (click to enlarge) So, at what point do returns become reliably positive? If we look at the historical data, we don’t have reliably positive returns from the stock market until we look about 5 years into the future, when the average 5-year returns become positively skewed. A 50/50 stock/bond portfolio has a purely positive skew, with an average rolling return of 3 years. Interestingly, this stock market data is just as random even though it’s positively skewed. So, trying to pinpoint what the 5-year average returns will be is probably a fool’s errand (even though stocks will be reliably positive, on average, over a 5-year period). (click to enlarge) All of this provides us with some good insights into the relevancy of making forecasts about future returns. When it comes to stocks and bonds, we really shouldn’t bother listening to or analyzing predictions made inside of a 12-month period. The data is simply too random. As we extend our time horizons, the data becomes increasingly reliable with a positive skew. But it still remains a very imprecise science. The bottom line – If you’re going to hold stocks and bonds, it’s almost certainly best to plan on having at least a 3-5 year+ time horizon. Any analysis and prediction inside of this time horizon is likely to resemble gambling. As Blaise Pascal once said, “All of human unhappiness comes from a single thing: not knowing how to remain at rest in a room”. The urge to be excessively “active” in the financial markets is strong; however, the investor who can take a reasonable temporal perspective will very likely increase their odds of making smarter decisions, leading to higher odds of a happy ending. Sources: ¹ – Can a company live forever? ² – Vanguard Total Bond Market ETF, Morningstar