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related weather conditions on the financial market mountain are going to change the one singular guarantee on everest yet although we know this capital continues to concentrate in equities for now after immense preparation and xpense the ultimate point of human frustration and mortal decision making for climbers on everest is being several hundred feet from the summit and having the weather turn bad does a climber acknowledge that survival risks have increased and turn back to descend the mountain perhaps missing a once in a lifetime chance to summit or does the climber make the decision to push ahead and plan to accelerate the descent once the summit has been reached essentially making the bet that they will stay ahead of changing weather and that there will be no time lost in a concentration of climbers all needing to traverse down the hillary step it all comes down to a personal assessment and implementation of risk management in decision making in the current cycle we are well along our trek to the financial market summit given the evidence of capital concentration we are seeing right now in equities we know we are increasingly moving above the hillary step which will again be confronted on our eventual descent at some point off in the distance we can see initial signs that the short term weather condition of liquidity is set to change although we cannot yet assess magnitude and timing of the change we know is to come we are not yet ready to call off the summit attempt and turn back in the current cycle but we know risks are increasing our attention should now be equally divided between the specific risks and demands of summiting and the risks and demands of the ultimate descent when the sherpa s refer to everest as chomolungma they are not simply describing the physical mountain chomolungma also incorporates the idea of the mountain god chomolungma is a reverential characterization do investors in the current financial market have the same reverence for the market mountain and a solid game plan for decision making when financial market weather conditions change we need to think about and incorporate this set of current environmental variables into planning our ascent descent well before our current summit attempt is over we need to elevate our focus on risk management we know heightened capital concentration risk in equities is growing although market trend remains positive the shorter term issue of market liquidity is now becoming a question mark in terms of fed policy although it can literally take a year to plan for and coordinate an everest summit attempt often it is success that can be measured in hours in the descent that determines survival the most successful climbers on everest focus equally on the ascent as well as the descent and even then there are no guarantees the same conceptual decision making constructs apply to us an investors posted in uncategorized leave a reply oh behave mr bond posted on july 26 2013 by contraryinvest reply over the last few months we have encountered heightened volatility in the bond market although treasury yields had been increasing in front of a mid june speech by fed chairman bernanke they have continued to run to the upside post the commentary without a whole lot of retracement up to this point heated fed backpedaling since mid june has succeeded in lifting equities to new heights but not so bonds i d like to discuss two topics i believe important first just what is the bond market discounting right now secondly equity bulls have again resurrected the great rotation story as of late you ll remember comments about this that made the rounds early this year the thesis being investors were on the cusp of rotating from bond holdings to stocks so far this year the mutual fund flow numbers have not validated this theory will they ahead as bond prices have now run into a bit of turbulence to answer this question i ll look at large institutional capital allocations of the moment just which investor groups have large bond holdings that could theoretically be sold as a potential funding source for stock purchases and what is the likelihood this rotation will occur with any type of investment it s always important to think about just what the financial markets are discounting in price at any point in time in terms of bonds perhaps the information new to the market over the last month is that the fed s quantitative easing qe program is not going to last forever to be honest we knew this all along we just had not heard bernanke say it out loud well now we have so in good measure the us fixed income market is attempting to discount in current bond prices just what will transpire with the fed s qe policy over time will they slow down their 85 billion per month bond purchases in september of this year or will that occur in 2014 will they taper the latest buzzword purchases over time and if so in what magnitude certainly these questions remain to be answered the volatility we are seeing in bond prices is a result of lack of clarity and specifics although this is nothing new bond investors are now attempting to discount a future that has become more uncertain post bernanke s comments last month personally i m wary of yet another issue related to the above that may also be getting into bond prices right now i m very wary that the markets may be starting to question fed credibility the expression of which is downside volatility in bond prices think about it over the last few months we have been treated to so many conflicting policy comments coming from fed members that i ve lost count i ve been personally convinced that a fed who cannot lift interest rates right now as bernanke told us in recent testimony the economy would tank if the fed raised rates will use jawboning to attempt to influence financial market behavior we saw many a fed member talk about qe curtailment over the mid may through june period were these fed members trying to cool down perhaps too hot equity and commodity markets with tougher talk if they were it had no effect as it took bernanke mentioning possible qe curtailment for investors to listen and both equity and commodity prices to temporarily correct but in the wake of this correction fed members immediately backpedaled on bernanke s qe tapering comments as they clearly did not like the very short term market reaction unfortunately the conflicting comments regarding policy continue to this day there is no uniform message among fed members one day a member suggests qe needs to stop by the end of the year the next day another fed member tells us the fed will remain very accommodative well into next year and beyond so just which one is it and how can investors make decisions when the fed members themselves are delivering conflicting messages intraweek is the failure of bonds to rally meaningfully as have stocks an expression of initial investor questioning of fed credibility the commentary flip flopping suggests the fed really has no well defined plan let alone magic bullets they are now simply reacting to short term market movements they have helped create with the all over the map policy quotes in the press i ve long wondered that after four years of unprecedented monetary policy with still very tepid at best economic growth just whether investors would lose faith in the fed and really global central bankers for that matter and politicians that time may have come and just how would financial markets price in a loss of faith we ll first see it in bond prices is this what the failure of bonds to meaningfully rally in the face of recent fed commentary back pedaling is really all about we know that since early 2009 faith in the fed s quantitative easing policy has been a major support to equity and bond prices we need to watch bonds closely ahead for a potential expression of a loss of faith that would be seen in price we may be seeing the initial signs of this right now if so what does this ultimately mean for stock prices we simply need to remember that in many past financial market cycles credit bonds has led equities in terms of price trends as always some of the most important market information can be found in price divergences between asset classes such as stocks and bonds we re seeing such a divergence right now as mentioned i want to switch gears a bit and come back to the great rotation theme will investors heavily exposed to bonds sell and rotate that investment into stocks now that bonds are acting a bit shaky it just so happens that we also may be getting the beginning of an answer to that question now we know that over the past four years many a retail investor has shunned stock investment in deference to purchasing bonds not surprising in that retail investors in equities have experienced two major stock market declines within the prior decade what also is not too surprising is that with the initial volatility we ve seen in bond prices since may retail investors have hit the sell button with little hesitation from mid may through june month end retail bond fund investors pulled just shy of 70 billion out of bond funds a record outflow so if indeed we are to see a great rotation from bond investments to stocks the important question is just where did this money go over this same period less than 500 million came into stock funds that s right less than 1 of the money that left bond funds for now by far the largest repository we ve seen for cash created by bond fund redemptions has been money market funds and bank deposits together growth in money funds and bank deposits combined over this period account for all of the proceeds from mutual bond fund sales that does not mean these assets will not ultimately gravitate to equities but there is no sign that this has yet happened for now the great rotation is an intriguing story that just happens to be lacking factual validation before concluding let s look at the current and historical asset allocation of a number of large pools of investment capital are there groups with still heavy exposure to bonds and how likely would it be that this exposure shifts to stocks two larger pools of institutional capital belong to pension funds and insurance companies in the us the following two charts show us the history of public and private pension fund allocation to bonds what the data above show us is that us public think municipal and government and private think corporate pension funds have the lowest or close to the lowest allocations to bonds in over a half century haven t these meaningful pools of capital already rotated away from bonds from an historical standpoint it sure looks that way i ll save you the historical retrospective of insurance companies as their historical bond investment allocation character is almost identical to what you see above banks in the us have always been large holders of bonds but at the moment bank holdings pale in comparison to the magnitude of bond exposure in the mutual fund complex and bonds held at the household level any change in bank investment posture simply cannot move the needle moreover there is little likelihood bank investment in bonds would migrate to equities as of the end of the first quarter or this year outside of the foreign community us households were the largest owners of individual corporate bonds households are the largest owners of municipal bonds and households are the third largest owner of individual treasury debt behind the foreign sector and the fed itself so as we look at household ownership of individual bonds as a percentage of total financial assets we see the following relative to history we re in middle ground right here yes households increased their bond ownership in the post 2007 2008 world but allocation relative to total financial assets remains modest a tsunami of money to come from household bond holdings just waiting to be liquidated let s just call it a potentially large swell that leaves us with the foreign pools of capital as i ve suggested in discussions this year the weight and movement of global capital is one of the most important investment themes of the year a theme i expect will continue into 2014 it s no mystery at all that foreign purchases of us bonds have been meaningful support to the broad us fixed income markets for really decades now in good part this has been a game of mercantilist economics trade surpluses generated by foreign countries exporting goods to the us have been recycled by these foreign countries into purchases of us bonds these purchases have helped keep us interest rates low and helped perpetuate us imports of foreign consumer goods china and japan have been the poster children for this type of activity as of the end of the first quarter of this year the foreign community is the largest holder of us treasuries and corporate bonds moreover foreign holdings of all types of us bond investments as a percentage of total foreign holdings of us assets rest just under 50 although this is a number near historical highs by no means is this something new if there is any sector that would be a viable candidate for a rotation from us bonds to stocks based solely on the character of current investment allocation it s the foreign community although it s a possibility is it a probability most foreign holdings of us bonds are held by official institutions governments and central banks as such their purpose is only partially related to rate of return on investment other agenda s such as cross currency rate manipulation supporting domestic export industries etc are high on the list of priorities for foreign holders of us bonds a wholesale movement into us equities is not a strong probability not even close the downside volatility we ve recently experienced in the us bond market is something new for the current cycle the recent divergence between us bond and stock prices demands attention as we move ahead this is punctuated by the fact that the fed is not buying stocks they are buying bonds yet stocks have zoomed to new highs while bonds struggle are us bond investors beginning to lose faith that fed monetary policy can right the still listing domestic economic ship further rising bond yields would suggest this may be the case we re not there yet but need to be mindful of a potential shift in investor perceptions in past cycles credit has led equities will it be so again one other character point of the current year is that investment diversification has hurt gold and commodities have struggled bonds globally have hit a pocket of price turbulence emerging market equities in many cases are gasping for breath the global investment leaders have been equities in countries whose central banks have engaged in high powered monetary policy specifically the us and japan in the race for investment performance it s now a very narrow playing field will investors with bond allocations rotate to equities ahead institutional asset allocatio...