The Psychology Behind Low Yields

Marketwatch had an article over the weekend about the recent success of the junk bond ETFs and some of the reasons why investors have been so keen on this space. Of more interest to me was a quote in the article from Doug Cliggott from Credit Suisse that focused on the investor psychology that has pushed the yield on the ten year US treasury below 3%. Cliggott cited three factors he believes are driving investors in this context.

Reason number one is "investors lowering their U.S. economic growth expectations." This was the weakest of the three in terms of investor psychology which was the point. I say that because no matter anyone's assessment of the current environment the bond market is being distorted by extreme policies that are attempting to stave off deflation.

While I have no doubt that growth expectations are eroding there are many moving parts to the ten year yield being where it is. There are many types of participants buying heavily across the curve like the Fed as recently announced and banks as many people have noted they have capital available to lend but are choosing not to do (borrowing at zero and buying treasuries).

Reason number two has much more psychological meat on the bone which Cliggott says "is good old-fashioned performance chasing." This is a behavior that repeats over and over. In the context of the article this could refer to the price appreciation of the ten year treasuries or the success of the junk bond ETF.

I think that this behavior occurs primarily for two different reasons. One being that there is comfort in seeing that something is doing well and concluding that the market must know something. "Seeing" can mean literally seeing what looks like a healthy chart pattern and feeling validated. This isn't necessarily bad in that some stocks or funds do go up a lot after they have already gone up a lot.

The other reason is probably similar to the first, that people extrapolate recent results. If the SPX goes back down to 1000 I promise there will be a parade of analyst calling for 900 or 850, likewise if we get back to 1150 they will be lining up to predict 1300. I remember early in the year Alec Young from Standard & Poors starting out the year with a somewhat bullish target for the S&P 500, the market got close or maybe hit it and so the target was bumped up. While I believe he has since ratcheted the target back down it underscores a very common thought process. If you think a stock trading today at $80 will be at $100 in one year and it gets there in eight months it could still be at $100 four months later, it doesn't have to keep going up with the same trajectory.

"Third, and perhaps the most important, is many Americans losing their appetite for risk." This is an area I've covered many times before. Assuming Cliggott is correct with this one, and I do agree with him, then what is going on here is that people have learned the hard way that they had the wrong asset allocation target (assumes no objective trigger for defense like a breach of the 200 DMA). During what turned out to be the worst of the market panic I commented that finding out you had too much in equities after a large decline is a very bad place to be. Despite the US market cutting in half at the start of the last decade many investors were caught off guard by the second 50% decline, they seemed to forget what the first 50% decline felt like.

Another point made previously is that too much allocated to something safe eventually becomes risky. Treasuries are "riskless" but buying to much of the wrong type at the wrong time can have disastrous results. Talking generically, for every percentage point that the yield of the ten year goes up, the price goes down about 12%. For an individual bond the holder can hold to maturity, not endure the loss just endure a below market yield. A bond fund like TLT has no par value to return to and a drop in price there could be permanent. Another example; people love MLPs but four years ago the Canadian versions (which were very popular back then) got pounded on news of a tax status change. Before then they were viewed as very safe (maybe they are back to being viewed as safe?).

The task here seems simple. If you favor some segment, done the legwork to decide you want in then you must weigh the consequence of being catastrophically incorrect. Chile is one of my favorite investment destinations. I've made the case as to why many times before so I won't repeat it now but the conclusions I draw could turn out to be wrong for reasons I might never see coming (this is generic and applies to every investment decision made). If that happens with Chile then what is my downside and can I live with that?

If I put 20% into the Chile Fund (CF) and it drops by 2/3s I have a big problem. That big problem would probably be compounded if I had a further 15% in the GobalX Colombia ETF (GXG). Some event that took Chile down that much would probably be bad news for Colombia too. At this point we might be talking deathblow. If on the other hand we are talking 3% to Chile and 2% to Colombia then the consequence becomes more of a drag than anything else. I believe 20% and 15% are way too much. I've had feedback over the years on the blog that the 2-3% per holding that I prefer is too small. Chances are the right numbers for many folks with normal equity tolerances are in between the two extremes. As a side note for long time readers I am moving to 5% per country as a ceiling with one country targeted at 4% right now but not there quite yet.

If you went down a lot in 2008 and into the start of 2009 then you should remember what that felt like and assuming you do not want a repeat you should figure out what you can tolerate without panicking and devise a plan to avoid getting to the point of panic. If whatever you devise has you underweight equities for a long time then so be it.

A couple of random items. Some readers may recall my "don't drink soda" rants; it is terribly bad for you. It turns out Barry Ritholtz appears to be on the same page. I thought that was kind of funny.

The other random item is from yesterday's Red Sox game. There were a couple of rain delays which made for a long game and day at the park for anyone there. Shortly before the game ended the camera found a fan who had fallen asleep. The announcers noted what a long day it had been. A few minutes later the same fan was either hit by a foul ball or it landed close enough to wake him up (presumably within a seat or two). Maybe Nassim Taleb would disagree but that to me is one example of a black swan.

The red you see on the branches are lady bugs.