Corner of Wall & Main: Year of the Bond

 | May 14, 2014 | 2:00 PM EDT  | Comments
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Stock quotes in this article:

tol

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ryl

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kbh

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fbhs

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mas

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usg

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TLT

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spy

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fcx

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nem

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pcl

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HDGE

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lnkd

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lulu

This week, as we watch the economy, the big topics are food, fuel and housing.

The only meaningful piece of economic data we received so far this week was the disappointing April retail sales figure. Many, including us, expected a positive bump in April given the late Easter holiday, but instead retail sales excluding autos were flat for the month and well below the 0.6% consensus forecast. More concerning, the year-over-year rise in gas and food prices likely inflated the reported figures for those categories. That means watching the PPI and CPI reports due later this week even more closely.

The big report will be Friday's April housing starts report. With no weather-related excuses, we will finally see the true demand for single-family housing. That could be a boon to homebuilders like Toll Brothers (TOL), Ryland Group (RYL), KB Home (KBH) and other homebuilders, as well as building product companies like Fortune Brands Home & Security (FBHS), Masco (MAS), USG (USG) and others.

This year has been a Peter Allen world in which everything old is new again.  After all the talk last year of how bonds were dead, so far 2014 has been the Year of the Bond. As the chart illustrates, the iShares 20+ Year Treasury Bond ETF (TLT) has outperformed SPDR S&P 500 (SPY) since the start of the year. But this rally in bonds is all about the desperate search for income in a world in which central banks are holding the risk-free rate at miniscule levels while the largest portion of the population in the U.S., much of Europe and Japan are nose to nose with retirement. This search is so desperate that we see Greek bonds trading near 5%! 

Who would have imagined at the height of the eurozone crisis just a few years ago that Spanish 5-year yields would end up in line with U.S. Treasuries at 1.6%. This rally in bond yields is clearly based on the belief that Fed Chief Janet Yellen and her team are not going to be raising rates any time in the meaningful future. Add in Vladimir Putin playing around in the Baltic without appearing to be concerned for the economic impact on Mother Russia and you've got a flight-to-safety doubling down on that angst for safe income.

But bond investors ought to be wary at the moment as there is essentially no yield protection, with bonds as the miniscule coupon won't make up for any meaningful rise in yields, which is likely. If we take a step back and put the hoopla about how bonds are handily beating stocks YTD in context, the 10-year U.S. Treasury yield is now 2.6%, but was 1.6% this time last year. With the Fed tapering and quite vocal about its near-religious belief that inflation is non-existent, we're more bearish than bullish on bonds despite their performance so far this year.

Alongside the rally in bonds, copper ended last week with its best rally in five weeks, up 1.6% last Friday in a trend upwards that has emerged since the metal recently hit a bottom in early March after peaking in early January.

Stockpiles of copper on the Chinese, U.K. and U.S. exchanges are down to their lowest levels in nearly six years, making downside risk on copper more comfortable than on bonds. Freeport-McMoRan (FCX) is a diversified natural resource company that produces oil, gas, cobalt, molybdenum and cobalt, but derives more than 80% of its revenue from copper production, which has taken a beating lately. The company has recently faced an exorbitant tax of 25% on exports of Indonesian natural resources, which led the company, along with Newmont Mining (NEM) to suspend all exports from the country.

Recently, the company reached a tentative deal with the Indonesian government to pay the government a 5% security bond and build a smelter in Indonesia in return for an exemption from the ban. The deal isn't firm yet, but given that FCX accounts for an enormous portion of the economy in the region, the government is likely to have plenty of incentives to be cooperative as it feels the pain of Freeport's export suspension. 

For those seeking additional protection from inflation and seek to diversify away from the stock market that's been rather much ado about nothing so far this year, Plum Creek Timber (PCL) is another excellent natural resource that provides an investment in timber, which is highly uncorrelated to stocks and is an excellent hedge against inflation, for those who think all this central bank tinkering may not end well.

Trees keep growing year after year, regardless of what insanity is going on in the markets, at central banks or on Capitol Hill. Forests are both lumber factories and warehouses, giving investors ultimate flexibility on harvest timing, plus, the longer you leave it in the ground, the more valuable it becomes. Over the last 100 years timber prices have risen more than 3% above the rate of inflation, according to Random Lengths. As the housing market recovers, additional demand for lumber for new construction will be a positive tailwind for the sector. Additionally, underneath all that timber sits valuable land, which puts a comfortable floor under share value. But like many stocks today, we think PCL is a bit expensive and are more comfortable with it in the low-to-mid $30s range, where its yield is closer to 5.25%.

For those of you who worry that the market may be getting a bit too hot for your comfort, a little hedging may be in order. We are very much in a stock-pickers world today, as opposed to the beginning of the bull run in 2009 and 2010, when correlations were insanely high. So, rather than looking to short the market as a whole, consider hedging against a downturn with an ETF that allows you to short just those that are most likely to take the biggest hits in a downturn. The AdvisorShares Ranger Equity Bear ETF (HDGE) looks to short companies that may be vulnerable to earnings misses or a reduction in guidance, either through aggressive accounting or deteriorating fundamentals.  It also looks for companies that are undergoing distribution, meaning stocks that are falling on heavy volume and rallying on light volume as opposed to momentum stocks.

The fund should do well if/when the market declines with limited downside risk if the rally continues. Think of this as insurance with the likelihood of greater upside potential than downside risk. The fund's top holdings include companies such as LinkedIn (LNKD) and Lululemon Athletica (LULU), both of which have been struggling to please investors. 

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